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SHOULD YOU CHANGE YOUR RETIREMENT PLANNING IN LIGHT OF THE NEW
Financial Planning Perspectives, 11/2003
Should you change your retirement planning in light of the new
The Jobs and Growth Tax Relief Reconciliation Act of 2003 raises
several questions regarding retirement planning. Should you reduce
your contributions to tax-deferred retirement accounts in favor
of taxable accounts? Should you change what types of investments
to put into taxable accounts versus retirement accounts? Does the
act affect investing for retirees differently than it does those
still saving for retirement?
Although the new act doesn't directly change the rules of tax-qualified
retirement accounts, the lowering of ordinary income-tax rates and
the rates on dividends and long-term capital gains is forcing a
rethinking of some retirement planning strategies, say many experts.
One of the first debates is whether you should still try to fully
fund your tax-qualified retirement accounts such as 401(k) plans
or individual retirement accounts. The argument for relying less
heavily on tax-deductible retirement accounts and more on taxable
accounts is that many taxable investment earnings are subject to
a lower tax rate than before. The act temporarily drops the maximum
capital gains rate from 20 percent to 15 percent, and from 10 percent
to a mere 5 percent for the lowest-income taxpayers (zero percent
in 2008). In the most dramatic change, the rates on most stock dividends
will equal the capital gains rates instead of being taxed as ordinary
Why not take advantage of these low rates by investing in taxable
accounts, argue some, instead of letting capital gains and dividends
grow inside retirement accounts where they generally will be taxed
at higher ordinary income-tax rates upon withdrawal?
Because you'll miss out on the benefit of the tax-deductible contributions
necessary to earn those capital gains and dividends, counter critics.
In short, you'll have less money available to earn the reduced rates,
thus offsetting the advantages. Moreover, if you belong to a retirement
plan at work you could miss out on the "free" money offered
when your employer makes matching contributions.
Also, workers are less likely to tap a retirement account than
a taxable account because if they do, they'll probably have to pay
ordinary income taxes and early-withdrawal penalties.
There's more agreement among experts that the new act does change
what type of assets are best to put into taxable versus nontaxable
investment accounts for those still saving for retirement. Assuming
you have fully funded your retirement account contributions, and
are saving for retirement in taxable accounts, the consensus is
to put individual stocks, dividend-paying stocks, and index or tax-managed
stock mutual funds in your taxable account and put investments that
generate annual income that's subject to ordinary income-tax rates
in your retirement accounts. These would include taxable bonds,
real estate investment trusts and stock funds with high annual turnovers.
The tax cuts on investment income may also help retirees. Retirees
typically rely on income-generating investments such as certificates
of deposit, bonds and REITs whose payouts are still subject to ordinary
income taxes. Some experts recommend that retirees decrease their
allocation to interest-paying investments and increase their allocation
in dividend-paying stocks and stocks that generate capital gains,
though such investments traditionally carry higher risk.
The lower capital gains rates also make more advantageous a less-well-known
tax strategy known as net unrealized appreciation. Workers who have
accumulated loads of company stock in the company's tax-deferred
retirement plan often roll all of their stock into an IRA when they
leave the company in order to keep deferring taxes. But it can be
more advantageous to withdraw the company stock and not roll it
over to the IRA. The employee will pay ordinary income taxes on
the stock-but only on the value of the shares when they were acquired,
not what they're worth now. The difference between the basis and
the current market price, which could be substantial, would be taxed
at the new lower capital gains rates if the stock were immediately
sold. The lower rates also will apply to new earnings from the stock
as long as the stock is held at least a year.
The challenge for making any of these changes to your retirement
investments is that all these tax-rate changes for investments expire
by the start of 2009 unless Congress votes to extend them or make
November 2003- This column is produced by the Financial
Planning Association, the membership organization for the financial
planning community, and is provided by Marnie Aznar, MBA, CFPÒ,
a local member of the FPA.