|EXECUTIVE SUMMARY |
| When individual clients receive an income tax refund, a bonus, an inheritance or another windfall or other extra cash, they have a number of options. The most prudent choices are investing, putting money in college savings or retirement accounts or paying off debts. By using the following step-by-step approach, CPAs can assist individual clients who are wage earners to make the most effective decisions on what to do with spare cash. Here are the steps:
Invest in a 401(k) or 403(b) retirement account up to the full extent of the employer’s matching contributions.
Pay off debts—beginning with those that have the highest after-tax interest rate.
For higher education costs, invest in the client’s state section 529 college savings plan up to the maximum amount eligible for state tax benefits.
Invest up to the maximum in either a Roth IRA or a deductible IRA. Invest up to the maximum allowed in a 401(k) or 403(b). For additional higher education costs, invest in any state’s section 529 college savings plan and/or a Coverdell account.
Pay off moderate interest rate debts in order based on the after-tax interest rate.
For further retirement savings, consider an annuity. For those who prefer to have cash available, invest in tax-efficient mutual funds such as stock indexes and/or government bonds.
Pay off lower interest rate debts in order based on the after-tax interest rate.
Gregory G. Geisler, CPA, PhD, is an associate professor of accounting, University of Missouri—St. Louis. His e-mail address is firstname.lastname@example.org .
hen individual clients receive an income tax refund, a bonus, an inheritance or another windfall—or even have some extra cash on hand after paying off their bills—they have a number of options. The most prudent choices are investing, putting money in college savings or retirement accounts, or paying off debts. To help clients rate these alternatives, CPAs should consider three criteria: the after-tax rate of return, the risk and the effect on asset diversification.
While risk tolerance and asset diversification decisions vary for each client, tax considerations generally apply across the board. With that in mind, this article offers a step-by-step approach to the options based on their after-tax rate of return, providing choices that offer tax advantages no matter how much money is involved. For simplicity, the article assumes that the individual client is an employee and not self-employed.
M AKE THE M OST OF M ATCHING C ONTRIBUTIONS
When clients have any available cash, their first choice always should be to increase retirement account contributions to the maximum employer match. Contributions to 401(k) or 403(b) retirement accounts that are fully matched by the employer yield an immediate return equal to the employer’s matching percentage. Up to a set limit, matching percentages generally range from 25 cents to $1 on each dollar contributed by the employee—an instant 25% to 100% return on the investment. For example, if a company offers a 50% match on the first 6% of pay, an employee with a $50,000 salary should contribute $3,000 to the 401(k) to receive the maximum matching contribution of $1,500 ($50,000 x 6% x 50%) from the employer.
PAY OFF HIGH-AND MODERATE-INTEREST- RATE DEBTS
The next most effective strategy is to pay down high-interest-rate debts, particularly credit card balances. Pay off debts in order of their after-tax interest rates, beginning with the highest. Paying the balance on a credit card with a 12% annual interest rate is the same as receiving an annual after-tax rate of return of 12% on a risk-free investment. If the client itemizes deductions, paying down a loan with deductible interest provides a risk-free rate of return effectively equal to the loan’s interest rate minus the marginal rate of tax savings forgone.
It’s not necessarily the best policy to use up all spare cash paying off debts, however. Generally, at this stage clients should continue to carry debts with after-tax interest rates in the range of 6% to 8% or lower (this can vary depending on the current interest rate environment). Below this interest rate range, clients should be able to find more effective uses for their money than paying off debts, though more conservative clients may disagree. Still, even conservative clients should not pay off debts with an after-tax interest rate below about 6% before proceeding to step 3.
PARTICIPATE IN A COLLEGE SAVINGS PLAN IF IT PROVIDES STATE INCOME TAX SAVINGS
Clients facing future higher education costs next should investigate state-sponsored tax-advantaged college savings plans. (Those who do not receive state income tax savings for their plans or aren’t facing these education costs should move on to step 4). In qualified plans covered by section 529 of the Internal Revenue Code, withdrawals generally are not subject to federal income tax if the money is used to pay for qualified educational expenses. If they are not, they are subject to federal taxes and a 10% penalty. If a child decides not to go to college, the funds generally can be used to pay for another family member. (For more on college planning, see “ Financial Aid 101, ” JofA , Jul.05, page 79.)
If a contribution to a 529 plan provides state income tax savings, then the client receives an immediate return on investment equal to that savings divided by the investment net of the state income tax savings. For example, in Missouri the marginal state income tax rate is 6% for most taxpaying residents. A $1,000 investment into a “Missouri MO$T” 529 account generates $60 of state income tax savings, which equals an immediate return of 6.38% ($60 / [$1,000 – $60]).
Individuals who invest in a 529 plan that produces state income tax savings always enjoy a better after-tax return than they would receive on the same investment for the same length of time in a Roth IRA, and generally enjoy a better after-tax return than in a traditional IRA or 401(k) plan. In addition, a small return on a low-risk investment in a 529 plan combined with the immediate return from the state tax savings provides a better after-tax return than paying down any remaining debts. As a result, clients who are expecting to pay future higher education costs should invest up to the amount that maximizes state income tax savings in their state’s 529 plan. To see whether a state offers tax savings, go to www.savingforcollege.com/529_plan_details , click on the state, click on a plan, then scroll down to “Taxes and Other Benefits.”
For help in choosing a 529 plan, see “ Rating 529 College Savings Plans, ” page 45.
Still have cash available? Go to step 4.
MAKE OTHER RETIREMENT INVESTMENTS
The next move is to contribute to a traditional IRA (if the client is eligible to take a deduction on the contribution; we’ll call this a deductible IRA) or a Roth IRA. At this point, clients also should contribute to any available 401(k) account—even if there is no employer match—and to any other employer-sponsored retirement plan that allows pretax contributions.
In what order should clients make these investments? To decide, CPAs first must consult the tax law to determine whether clients are eligible to use each option and the maximum allowable contribution. (The rules on who can contribute and how much to deductible and Roth IRAs can be found in IRS Publication 590 at www.irs.gov/publications/p590/index.html .) Then they should estimate their client’s tax rate at retirement.
In general, for clients who expect their marginal tax rate in retirement to remain the same as it is currently, a 401(k) or a deductible IRA is equivalent to a Roth IRA. To see why, assume a client with a 30% marginal tax rate has $2,800 in spare cash available for the year. Also, assume a 5% rate of return and a 15-year investment horizon. The investment in a Roth IRA of $2,800 would grow to $5,821. The investment in a 401(k) or a deductible IRA of $4,000, which includes both $2,800 spare cash and $1,200 ($4,000 x 30%) of tax savings, would grow to $8,316. At the 30% rate the client would pay $2,495 in taxes on the $8,316 distribution, leaving $5,821 after taxes. That’s the same amount as the Roth IRA distribution, which is not subject to tax.
If the client’s expected tax rate will be lower in retirement, though, it’s better to invest in a 401(k) or a deductible IRA to the extent eligible instead of a Roth IRA. Assuming the same facts as above except that the client’s expected tax rate at retirement is 20%, the tax the client would pay $1,663 in taxes on the $8,316 distribution from the 401(k) or deductible IRA, leaving $6,653—more than the $5,821 from the Roth IRA. If a client is not eligible to contribute to a deductible IRA but is eligible to contribute to a Roth IRA, he or she should contribute up to the maximum allowable amount to a 401(k) before considering contributing to a Roth IRA.
If the client’s expected tax rate will be higher in retirement, the Roth IRA is the better choice. To understand why, let’s again assume the same facts as above, except that the client’s expected tax rate at retirement is 40%. The client would pay $3,326 tax on the $8,316 distribution from the 401(k) or deductible IRA, leaving $4,990—less than the $5,821 from the Roth IRA.
A 401(k) and a deductible IRA effectively receive the same tax treatment—so which should a client choose? Be aware that investment choices in employer-sponsored retirement plans may be limited. The average 401(k) offers only 15 mutual funds to which employees can contribute, according to the “46th Annual Survey of Profit Sharing and 401(k) Plans” by Profit Sharing/401(k) Council of America. In contrast, there are thousands of mutual funds to choose from when investing in an IRA. So, consider the quality of investment choices available through the 401(k) plan.
At this point, clients who need to save for future higher education costs should contribute to a 529 plan, even if the contribution provides no state income tax savings, and/or to a Coverdell education savings account. The tax treatment of contributions to a Coverdell account and such a 529 plan are effectively the same as for a Roth IRA, because none of these options provides a tax deduction for a contribution or carries any tax cost on either the investment’s earnings or qualified withdrawals. Coverdell accounts can be used for elementary, secondary or higher education expenses, while 529 plans are limited to higher education expenses. Series EE U.S. savings bonds are another college savings option, but the associated income limitations mean that far fewer individuals qualify for tax-favored treatment than would for a Coverdell account. Section 529 plans generally do not have income limitations.
MAKE PERSONAL INVESTMENTS AND PAY O FF LOW- INTEREST RATE DEBTS
If a client has taken advantage of the options in the previous steps and wants to accumulate more retirement savings, it’s time to consider investing in an annuity. Annuities offer deferred taxes on earnings until payments are received but do not provide any of the other tax advantages that investments in earlier steps do.
For those who prefer not to tie up cash in an annuity, one alternative is to buy tax-efficient, diversified mutual funds such as stock index funds. Qualified dividends and long-term capital gains currently are taxed at a maximum rate of only 15%, much lower than on ordinary income such as interest and short-term capital gains. Another alternative for clients with relatively low risk tolerance is mutual funds that invest in federal government treasury bonds, whose earnings are free from state income tax, or state and local (municipal) bonds, whose earnings are free from federal income tax (and, in many states, free from state income tax if the bonds are issued by the client’s state of residence and its political subdivisions). A municipal bond fund can provide further diversification of assets. Note that tax-advantaged bond funds are not good investments for IRAs and 401(k)s because these are tax-deferred accounts, so the tax advantage is lost. Corporate bond funds and REITs are much better options. Also, stock funds are often chosen for IRAs and 401(k)s because of their growth potential.
Finally, it’s a good idea to pay off remaining debts. Pay down loans with nondeductible interest (such as auto loans with low financing rates) and loans with deductible interest (such as mortgage or home-equity loans). Begin with those with the highest after-tax interest rate. As mentioned earlier, paying down such loans provides a risk-free rate of return equal to the loan’s after-tax interest rate. Risk tolerance can influence the order in which the client selects options at this stage. A conservative client, for example, might want to pay off even a low-rate mortgage loan before investing any available cash in personal accounts.
| Always begin by taking advantage of the maximum matching contribution from an employer’s retirement plan.
List all debts according to their annual interest rates, from highest to lowest, and adjust the interest rate to its after-tax interest rate. Use this list to determine the order for paying off debts.
Individual clients have many options when extra money becomes available. While each situation is unique, the steps in this article can serve as a template. By guiding clients through their choices—from most to least advantageous based on after-tax rates of return—CPAs can help them make sound and satisfying decisions.