Investment Tax Planning for Retirement

How to make taxes work for the client.

FOR CLIENTS DREAMING OF A FINANCIALLY SECURE retirement, CPAs need to offer assistance on which savings vehicles—qualified and nonqualified—will help them reach their goal. This decision involves both tax and nontax considerations.

CLIENTS PREPARING FOR RETIREMENT HAVE a wide variety of savings vehicles available to them including 401(k) plans, regular and Roth IRAs and other qualified plans. CPAs can recommend clients also set aside funds in other aftertax investment vehicles.

IN RECOMMENDING RETIREMENT SAVINGS OPTIONS, CPAs have to keep in mind certain rules including minimum distribution requirements, premature withdrawal penalties and liquidity concerns.

CLIENTS SHOULD CONTRIBUTE AS MUCH AS POSSIBLE on a pretax basis to their 401(k) plans, particularly those that offer employer matching, which immediately boosts the plan’s “return.” Clients over age 50 can make additional, catch-up contributions.

THERE ARE SOME SAVINGS OPTIONS CPAs SHOULD encourage clients to avoid. These include tax-deferred annuities, which usually carry high fees, and nondeductible IRAs; a Roth IRA would be a better alternative.

DELTON L. CHESSER, CPA, PhD, is the Roderick L. Holmes Professor of Accounting at Baylor University in Waco, Texas. His e-mail address is . WALTER T. HARRISON JR., CPA, PhD, is professor of accounting at Baylor University. His e-mail address is . WILLIAM R. REICHENSTEIN, PhD, is professor of finance and the Pat and Thomas R. Powers Professor of Investment Management at Baylor University. His e-mail address is .

s many Americans do, Sam and Sue dream of a stress-free retirement—enjoying an Alaskan cruise, visiting New York City or just strolling through the park. For this couple, tomorrow cannot come soon enough. Regrettably, for some retirees tomorrow may bring with it some disappointment.

Living one’s retirement dreams requires much more savings and financial planning than most people realize. Today’s prospective retirees are experiencing neither the increase in real income nor the corporate stability that past generations have enjoyed. Employers have shifted the risk of preparing for retirement to employees by replacing defined-benefit plans, which offer a guaranteed monthly retirement benefit, with defined-contribution and 401(k) plans, which are not guaranteed.

Couples such as Sam and Sue—and single individuals as well—realize they need help preparing for retirement and are turning to their CPAs for professional help. One question clients have is whether they should put their savings in tax-deferred or taxable accounts. They think tax-deferred investments would be better for them, but they don’t fully understand the impact taxes will have on their retirement savings. And they worry about the liquidity of those funds and any related premature-withdrawal penalties. In addition they wonder what effect tax-rate changes after they retire will have on the savings vehicles they select today. This article answers these questions and provides a framework to help CPAs counsel clients like Sam and Sue on their choice of retirement savings vehicles.

Saving for Retirement

Of those between the ages of 50 and 61

31.2% have a 401(k) plan.

41.1% have contributed to an IRA or Keogh account.

52% are covered by a pension plan.

Source: AARP, Washington, D.C., .

CPAs can begin this process by identifying available savings vehicles. Clients have several options for accumulating retirement capital—among them taxable accounts, deductible pension plans, nondeductible IRAs and Roth IRAs. The various vehicles are best categorized by their tax treatment. Clients who understand the differences can make better decisions about how best to accumulate funds for their retirement. Most likely, they will use more than one vehicle to accomplish their goals.

Exhibit 1 summarizes the tax treatment of some of the more common savings vehicles. The tax consequences differ at inception, during the investment period and at withdrawal. At inception, the initial savings amount the clients place in a taxable account, a nondeductible IRA or a Roth IRA is made with aftertax dollars. Deductible pensions are funded with pretax dollars because these contributions escape current taxation.

Exhibit 1: Online Compliance Resources
Savings vehicles Tax treatment of initial investment Tax treatment during investment period Tax treatment at withdrawal
1. Taxable account Aftertax dollars Taxable at either ordinary or capital gains rates No additional tax is due because tax was paid during the investment period.
2. Deductible Pretax dollars Tax-deferred Initial investment and earnings pension account* are taxed at ordinary rates.
3. Nondeductible IRA Aftertax dollars Tax-deferred Only earnings are taxed at ordinary rates.
4. Roth IRA Aftertax dollars Tax-exempt Initial aftertax investment and earnings are tax-exempt.

* Includes defined-contribution plans, profit-sharing plans, 401(k) plans, 403(b) plans, 457 plans, Keogh plans, Simplified Employee Plans (SEPs), SIMPLE plans and deductible IRAs.

During the investment period, the returns a taxable account generates are taxed annually at either ordinary income or capital gains rates. In contrast, returns are not taxed in deductible pensions, nondeductible IRAs or Roth IRAs. At withdrawal, the accumulated returns in a nondeductible IRA are taxed at ordinary income tax rates. In a Roth IRA, withdrawals are tax-free (if the client began the Roth at least five years earlier and takes withdrawals after age 591¦2). In a deductible pension, all withdrawals are taxed at ordinary income rates.

Sam and Sue both are 52 years old and plan to retire in nine years. They have taxable income of $100,000 before considering any deductible retirement accounts. Since their combined federal and state income tax rate totals 35%, they have $65,000 of aftertax income. Because the couple needs only $59,000 to meet their living expenses, they plan to save $6,000 of aftertax dollars each year for the next nine years. Unless unexpected emergencies occur, the couple will not need to use these funds before age 72. Sam and Sue participate in their respective employers’ 401(k) plans, and each is eligible to contribute up to $12,000. Their employers match 50% of the first $5,000. Each spouse expects to contribute $5,000 annually.

Sam and Sue need help determining the savings vehicles that will provide them with the greatest amount of aftertax funds in 20 years. Because of employer matching, their first contributions should go to their 401(k) plans. Putting $5,000 in such a plan is the equivalent of investing $7,692 in aftertax dollars. The employer’s matching contributions gives taxpayers like Sam and Sue an immediate 50% return on their investment.

The next decision involves where the couple should invest their remaining $6,000. To help them determine this, the CPA can assume their tax rate will remain at 35% during the couple’s working years and will range from 15% to 40% during retirement. These rates reflect the added effect of state income taxes. Investments are expected to earn 7% pretax annually.

Exhibit 2 shows that the deductible pension and Roth IRA would provide the couple with substantially greater accumulated aftertax funds than the other two savings vehicles. Whether Sam and Sue should choose deductible pensions that don’t offer matching contributions or Roth IRAs depends mainly on the relationship between their expected income tax rate during retirement and their current rate. Rates lower than 35% during retirement favor deductible pensions, while rates greater than 35% favor Roth IRAs. In the case of Sam and Sue, lower rates mean the “added accumulation” of $81,454 ($232,725 – $151,271) from investing in a deductible pension will exceed the related tax bill. For example, a 15% tax rate during retirement results in a tax bill of $34,909, which is more than offset by the additional $81,454. Exhibit 2 shows that when the tax rate during retirement is more than 35%, the Roth IRA becomes the preferred choice because the final tax liability exceeds the added accumulation of $81,454.

Exhibit 2 : Aftertax Balance in 20 Years

Retirement accounts, other than Roth IRAs, have minimum withdrawal requirements. Individuals must begin withdrawing funds from deductible pensions by April 1 of the year following the year they turn age 701¦2. Failure to do so can result in a 50% excise tax levied on the amount by which the required minimum distribution exceeds the actual distribution. Roth IRA withdrawals do not have minimum distribution requirements, nor do they affect taxes paid on Social Security benefits. Withdrawals from deductible pensions, on the other hand, can affect how much tax a retiree pays on his or her Social Security benefits.

All tax-favored retirement accounts have liquidity restrictions. In general, a 10% penalty tax applies to withdrawals from retirement accounts before age 591¦2. This restriction is seldom as pressing as it seems.

If the savings are for retirement, this penalty tax rarely comes into play since few people retire before this age.

About 75% of pension plans sponsored by large employers allow participants to borrow against their retirement accounts.

Withdrawals for disability, major medical expenses or other special circumstances before age 591¦2 are not subject to the penalty tax.

Again, Roth IRAs receive special consideration. In addition to the above reasons, Roth withdrawals escape the 10% penalty when used for a first-time home purchase (this distribution must be less than $10,000). Also investors can withdraw their contributions (not earnings) from a Roth IRA at any time without incurring income or penalty taxes. Any such withdrawals are first considered to be contributions. After 10 years the tax advantages of Roth IRAs and deductible pensions are so great that their aftertax accumulated amounts, even reduced by the 10% penalty, still would exceed the accumulated amounts in most taxable accounts.

These withdrawal requirements and liquidity restrictions favor the Roth IRA over the deductible pension, particularly when the clients’ tax rate during retirement equals or exceeds the current rate.

CPAs can now recommend other savings vehicles that will enable their clients to accumulate additional aftertax retirement funds. First, as discussed above, they should direct their savings to 401(k) plans that receive matching employer contributions. A 50% matching contribution provides the client with an added 50% rate of return on these accounts.

Next they should decide whether to place any remaining cash in deductible pensions without matching contributions or in Roth IRAs. As previously discussed, this decision is heavily influenced by the relationship between the clients’ current tax rate and the expected rate during retirement. Higher tax rates in retirement tend to favor Roth IRAs. If the clients are concerned about withdrawal requirements and liquidity restrictions, this further favors Roth IRAs. Lower tax rates during retirement make deductible pension funds the more attractive option.

Because Sam and Sue should save all they can in deductible pensions and Roth IRAs, it was fortuitous that the Economic Growth and Tax Relief Reconciliation Act of 2001 significantly increased contribution limits for these vehicles. Exhibit 3 shows that in 2003, a taxpayer can individually contribute a maximum of $3,000 to an IRA plus another $500 if she or he is over age 50. Sam and Sue can invest a maximum of $12,000, plus the $2,000 catch-up contribution the 2001 act permitted for taxpayers over age 50, in their 401(k) plans. Exhibit 3 also includes contribution limits for other plans that might apply to Sam and Sue if their employment status changes in the future and to other clients like them.

Exhibit 3 : Contribution Limits to IRAs and Deductible Pensions
  Traditional and
Roth IRAs
401(k), 403(b),
457 plans
SIMPLE plans Keogh plans SEP-IRA plans
Year Regular contribution Catch-up* contribution Regular contribution Catch-up* contribution Regular contribution Catch-up* contribution Regular contribution Regular contribution
2003 $3,000 $500 $12,000 $2,000 $8,000 $1,000 $40,000 15%
2004 $3,000 $500 $13,000 $3,000 $9,000 $1,500 Indexed† 15%
2005 $4,000 $500 $14,000 $4,000 $10,000 $2,000   15%
2006 $4,000 $1,000 $15,000 $5,000 Indexed† $2,500   15%
2007 $4,000 $1,000 Indexed† Indexed†   Indexed†   15%
2008 $5,000 $1,000           15%
2009 Indexed† $1,000           15%

* Eligible individuals 50 years or older at end of the year can contribute this additional amount.

† Indexed for inflation.

Source: Adapted from Integrating Taxes and Investments, William Reichenstein and William W. Jennings, Wiley Press, January 2003.

Because Sam and Sue can expect future salary increases, may change jobs or decide to save more money, they also may seek advice about savings vehicles to accommodate these changes. Earlier recommendations would remain unchanged. Currently, neither spouse can invest in a deductible IRA because both participate in employer-sponsored retirement plans and their adjusted gross income exceeds $54,000. But if in the future either qualifies for a deductible IRA and has to choose between a Roth IRA and a deductible IRA, the same analysis used in exhibit 2 applies. Again, the choice largely depends on the couple’s expected tax rates before and during retirement.

Exhibit 2 shows that a Roth IRA yields the highest return under expected high future tax rates. But if Sam and Sue fail to qualify for a Roth IRA because their adjusted gross income exceeds the allowed limit (currently $160,000 for married couples filing jointly) they should consider a nondeductible IRA. Any taxpayer with earned income, regardless of amount or participation in any other qualified retirement plan, is eligible to contribute to a nondeductible IRA. Exhibit 1 shows the major difference between the two is that the government levies ordinary income taxes on earnings a taxpayer withdraws from a nondeductible IRA while all Roth withdrawals are tax-exempt.

CPAs should remind clients that an individual’s maximum contributions to all IRAs except the SEP IRA and the Coverdell Education Savings Account (formerly the Education IRA) is $3,000 annually before considering any catch-up contributions.

Both now and in the future, taxable accounts should be Sam and Sue’s last choice as savings vehicles. Some financial advisers offer nonqualified tax-deferred annuities as an investment alternative. These annuities are essentially high-cost nondeductible IRAs. Clients invest in both vehicles using aftertax dollars that grow tax-deferred. The earnings are taxed at ordinary rates upon withdrawal. Although the tax treatment may be the same, the rates of return are not. Unlike a nondeductible IRA, a deferred annuity is an insurance product that typically carries additional annual fees of 1.25%, lowering the rate of return. Therefore, the nondeductible IRA is the

Studies show that nonqualified annuities are usually preferred over taxable accounts only when the insurance fees are low—for example, below 0.5%—and the investment horizon is long—say, greater than 12 years. Because the typical fees exceed 0.5%, CPAs should advise couples to invest in taxable accounts before buying nonqualified tax-deferred annuities. If the clients are averse to taxable accounts, advise them to consider municipal bonds or other tax-exempt investments.

CPAs should advise clients considering taxable accounts to select investments that minimize expenses and get the most benefit from the federal long-term capital-gains tax rate. Changes in the Jobs and Growth Tax Relief Reconciliation Act of 2003 make the taxation of long-term gains even more favorable, as well as offering preferential rates on stock dividends. Most long-term capital gains after May 5, 2003, will be taxed at a maximum rate of 15% (down from 20%). For tax years beginning after 2003, dividends noncorporate taxpayers receive from domestic corporations will be taxed at 15% (or at 5% for taxpayers in the two lowest tax brackets).


Clients should direct their initial retirement savings to a 401(k) plan if their employer offers one. These plans offer professional management and employer matching up to certain limits.

A Roth IRA provides investors with a substantially greater aftertax return than a taxable investment or a nondeductible IRA.

Keep minimum distribution requirements and premature withdrawal penalties in mind when recommending savings vehicles based on the client’s projected retirement age and need for income to supplement pensions and Social Security.

The high fees associated with nonqualified tax-deferred annuities mean they are seldom the best alternative for clients saving for retirement. Generally even a nondeductible IRA is a better option.

With all that has happened in the investment markets, many clients, Sam and Sue included, are concerned their vision of retirement may not become a reality because they won’t have enough money. To make sure this doesn’t happen, one of the greatest services CPAs can offer clients is to help them save in a tax-savvy manner. Not only is it important to save; it also is important to do so in the most tax-favored way. The understanding CPAs have of the tax laws gives them a distinct advantage over other investment professionals when it comes to making sure these rules work for clients not against them.

Resources . Advice on retirement finances and lifestyle issues from the organization formerly known as the American Association of Retired Persons. . Guidance from the U.S. Department of Health and Human Services Administration on Aging. . Includes access to the Morningstar Retirement Center. . Information on retirement and estate planning. . Everything there is to know about this popular retirement plan. . Advice for adults over 50. . An organization that helps individuals set priorities for their retirement years.

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