No matter who's elected president, there is a good chance taxes are going up. But that doesn't mean tax-deferred accounts are a bad idea.
Lately, readers have been writing in, fretting that tax-deductible individual retirement accounts and 401(k) plans will mean huge tax bills in retirement.
But even if tax rates leap, these accounts will likely remain a great investment. My advice: Keep funding that 401(k) -- but, if you're planning a 2007 IRA contribution by the April 15 deadline, plunk it in a Roth account. Here's why.
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Under pressure. Republican front-runner John McCain and Democratic contenders Hillary Clinton and Barack Obama are all proposing middle-class tax relief. But forget the campaign promises and focus on the inevitable: The tax code has to be rewritten -- and the result will probably be higher taxes.
In fact, we're facing a barrage of bad tax news. We need to fix the alternative minimum tax. Many of the Bush tax cuts are set to expire. The absurdly complicated tax code needs to be simplified. We have a sizable budget deficit. We need to pay for Social Security and Medicare for retiring baby boomers.
All this could be damaging for 401(k) plans and tax-deductible IRAs. You might save 25 cents in taxes by stashing $1 in these accounts -- only to give back 33 cents when you withdraw money in retirement. Worried? Don't be.
Still winning. Suppose you are in the 25% federal income-tax bracket and you earn an extra $5,000 this year, which you want to invest. The stock fund you pick goes on to notch 9% a year, and it doesn't make any taxable distributions.
Would you make more if you held the fund in a regular taxable account, where the fund's appreciation will eventually be taxed at the top 15% long-term capital-gains rate, or in a 401(k), where withdrawals will be taxed as ordinary income?
Three tips for handling retirement accounts.
• Always save enough in your 401(k) to get the full employer match.
• Hold bonds in a retirement account, thus deferring taxes on the interest.
• If you fear income taxes will rise, favor the Roth over a regular IRA.
The surprising answer: Even if your income-tax rate jumps sharply, the 401(k) will likely be the better bet, calculates Allan Roth, a financial planner in Colorado Springs, Colo. Indeed, if you have 15 years to invest, the 401(k) will leave you with more money, as long as your tax bracket doesn't climb above 33%.
If your time horizon is shorter, things are dicier. But even if you have a mere five years to invest, the 401(k) will leave you richer, provided your tax bracket doesn't rise above 28%.
How can the 401(k) be a better investment, given the hefty tax on withdrawals? In the example above, if you fund the 401(k), you can invest the full $5,000. But if you opt for the taxable account, you will first lose 25% of your earnings to taxes, leaving you with just $3,750 to invest.
Given that initial hit, it's no surprise the taxable account rarely wins. Figure in any employer match on your 401(k) contributions, and the 401(k) is pretty much unbeatable.
Triple play. As savvy readers will have noticed, we're making a big assumption here -- which is that rising taxes mean rising income-tax rates. Congress, however, may have other plans.
To protect yourself, try a three-pronged strategy. First, stash at least enough in your 401(k) to get the full employer match. Use the account to hold your portfolio's bonds. The interest will be taxed as ordinary income anyway -- and the 401(k) will allow you to defer the bill.
Next, if you're eligible, fund a Roth IRA. The Roth won't give you an initial tax deduction, but all withdrawals should be tax-free.
Finally, if you have additional money to save, buy stock-index funds or tax-managed stock funds in your taxable account. These funds should generate modest annual tax bills, and when you sell, the realized gain will be dunned at the capital-gains rate.
What's the advantage of all this? If income-tax rates rise, that could cut into the value of your 401(k) withdrawals. If capital-gains rates climb, it will hurt your taxable account. And if the income-tax system is ever replaced with a national sales tax, the Roth will lose its luster. In other words, you've spread your tax risk -- and thus you should be in good shape, no matter what Congress does.
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