EXECUTIVE SUMMARY
| 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
Del_Chesser@baylor.edu . WALTER T. HARRISON JR.,
CPA, PhD, is professor of accounting at Baylor
University. His e-mail address is Tom_Harrison@baylor.edu
. 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 Bill_Reichenstein@baylor.edu
. |
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. | |
ACCUMULATING ASSETS FOR RETIREMENT 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.
AFTERTAX RETURNS 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
| |
WITHDRAWAL AND LIQUIDITY CONCERNS
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.
SUGGESTED SAVINGS VEHICLES 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. |
FUTURE INVESTMENT CONSIDERATIONS
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). |
|
PRACTICAL TIPS TO
REMEMBER
|
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. | |
HOW TO BE TAX SAVVY 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. |