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
geisler@umsl.edu
.
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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.
STEP 1
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.
STEP 2
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.
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.
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.
STEP 4
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.
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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.
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A WORKABLE PLAN
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. |