The key advantage of stashing money in a tax-deferred retirement account isn't just that you'll pay less to the government this year, but that your investments will compound faster than in a taxable account. The result is usually a larger retirement nest egg even after the funds are taxed upon withdrawal.
In tax-deferred accounts such as a 401(k), a Simplified Employee Pension (SEP) plan, Individual Retirement Account (IRA) or a Keogh plan for the self-employed, dividends and interest income are not subject to tax until funds are withdrawn after retirement. This means not only lower taxes in the current year but also a larger base in each successive year for that year's growth. Hence, the overall accumulation is accelerated.
Some types of investments work better than others in these accounts. Here are some general Guidelines to consider when funding your tax-deferred retirement account.
One investment you should never put inside a tax-deferred account is tax-exempt bonds. That's because the interest is already tax-free, which is why tax-exempts generally yield less than comparable taxable bonds.
If you put tax-exempts inside a retirement account, the earnings will be taxed as regular income when you withdraw them. The result would be to turn a tax-free investment into a taxable one - and that's not a wise move.
These investments are excellent candidates for inclusion in your tax-deferred retirement account.
The income from taxable bonds and bond mutual funds is subject to federal and state taxes. By holding them in a qualified retirement plan you defer those taxes until you withdraw them in retirement, when your tax bracket may be lower because your annual income is reduced.
This tax deferral is particularly valuable for deep discount and zero coupon bonds, which generate no current income but incur annual taxes.
Like bonds, individual stocks and stock mutual funds whose returns come mostly from dividends, not price appreciation, should be kept in tax-deferred retirement accounts.
Financial experts are divided on the wisdom of keeping these stocks in tax-deferred accounts.
Some say it is better to keep these stocks in taxable accounts because most of their gain is from price appreciation, which you don't pay taxes on until you sell the stock. When you do sell a growth stock, it is taxed at the capital gains rate, which is often lower than a taxpayer's regular income tax rate.
The maximum capital gains tax is 28 percent, while personal tax rates for upper-income taxpayers can go as high as 39.6 percent.
If growth stocks are held inside a retirement account, you might be trading in a 28 percent capital gains tax for a higher tax rate, depending on your income and tax bracket. You also lose the ability to offset capital gains with capital losses when stock is held inside a retirement plan.
However, a 1995 study in the Journal of Investing says this strategy of keeping growth stocks out of your retirement accounts works only if you buy and hold a stock for a long time.
If you are an active trader, you may do better putting the stocks inside your tax-deferred account. That way you'll be taxed only once when you withdraw the funds rather than paying taxes on each transaction.
Mutual funds investing in growth stocks may be good candidates for inclusion in your tax-deferred retirement account. That's because these funds usually buy and sell a lot of stocks each year.
By law, they are required to pass 98 percent of their net investment earnings, including capital gains, on to their shareholders. Unless you keep them in a tax-deferred account, you'll be taxed on these gains each year.
Since tax-deferred retirement accounts have limits on how much you can contribute each year, don't use up those quotas with low-yielding investments like money market funds. Why protect something that is only earning 3 percent or 5 percent interest? Better to reserve this valuable tax deferral for investments that warrant protection.
On the other hand, if yields were to rise significantly in the future, it might make sense to shelter interest income from taxes with a tax-deferred account.
Whatever you invest in, the most important thing is to contribute as much as possible to your tax-deferred account. Not only will you pay less on current income and increase your future retirement income, but you may also reduce your taxable income if your contribution qualifies for a tax deduction.