Taxable Accounts – Still a Good Deal

Much has been written about the benefits of retirement-oriented savings vehicles – 401(k)s, 403(b)s, IRAs, Roth IRAs, and similar types of plans.

Such vehicles provide a number of benefits. Most offer tax deferral on contributions and on earnings/growth and, for some, the added bonus of an employer match. The Roth IRA has no upfront tax deduction for contributions but offers tax-free earnings/growth. Additionally, because of these benefits, millions of workers, who otherwise might not be saving for retirement, are responsibly saving on a regular basis.

However, the truth for most folks is that a combination of 401(k)/IRA/Roth IRA savings plus Social Security benefits will not provide enough to fund a comfortable retirement. Where will the rest come from?

While a purchased annuity is one option, there is another option that is more flexible and now more attractive from an income tax perspective, given the JGTRRA of 2003 (the formal name for the most recent tax cuts). That option is “taxable accounts”. While it is true that taxable accounts do not offer upfront tax deductions/credits and tax-deferred growth (or for a Roth IRA, tax-free growth), they do offer a number of advantages compared to the 401(k)s and IRAs. These advantages make taxable accounts very attractive complements to the standard retirement plans:

•  No contribution limits – Standard retirement plans have a maximum annual contribution cap. 401(k) plans  this year, for example, are capped at $12,000 plus $2,000 additional for those age 50 or older. IRAs and Roth IRAs are capped at $3,000 plus $500 additional for age 50 or older. Taxable accounts have no contribution limit.
•  No income limits – All tax-advantaged plans have income limits. Employer plans limit the degree of participation for workers with high incomes through anti-discrimination rules. IRAs and Roth IRAs impose income caps which prohibit contributions for years in which the caps are exceeded. A taxable account is available to anyone, regardless of income.
•  Easy access to funds – Unlike employer retirement plans, taxable accounts are not burdened by restrictive loan or hardship withdrawal provisions. And, unlike IRAs and Roth IRAs, they do not involve 10% early withdrawal penalties. Account holders can get at their money when they want it.
• Investment flexibility – Participants in employer retirement plans are limited to the investment choices chosen by their employers. Also, many IRA and Roth IRA investment choices are limited by the account administrator. With a taxable account, investment choices are unlimited.
• Tax flexibility – Regular taxable accounts have one big advantage over tax-deferred retirement accounts: long-term gains on capital assets and most stock dividends are now taxed by the IRS at very low rates – 5% (for 10% and 15% marginal tax brackets) or 15% (for 25%-35% tax brackets). Contrast this with tax-deferred accounts that ultimately generate taxes on all distributions at ordinary income tax rates as high as 35%.
• No minimum distribution requirements – Employer retirement plans and IRAs require account owners to take regular distributions starting at age 70-1/2, even if the money is not needed. The same is true, regardless of age, of inherited IRAs/Roth IRAs. Such distributions may elevate the taxpayer’s marginal tax rate and may also cause more Social Security benefits to be taxed. Distributions from a taxable account are much more “kind” in terms of impacting the income tax bill, both Federal and state.
• Estate planning flexibility – Assets in regular taxable accounts can be transferred to heirs at a stepped-up tax cost basis or may be gifted during lifetime in a way that suits the owner(s). Options for retirement plans and IRAs/Roth IRAs are much more limited. Lifetime transfers, for example, are not allowed. And while retirement/IRA/Roth IRA assets smoothly transfer on death by beneficiary designation, such transfers for non-spouse beneficiaries can result in an immediate tax obligation (most company retirement plans) or in a requirement that the beneficiaries take distributions over their lifetimes with an associated tax consequence – all at ordinary income tax rates.

Does all of this imply that taxable accounts are good and retirement/IRA/Roth IRA accounts are not? No, not at all. Each has its pros and cons. A well-designed financial plan can outline the correct mix of each, depending on an individual’s specific goals, access to various plans, income level, time to retirement, and other factors. A trusted financial planner should be consulted to help you determine what is right for you.

James Terwilliger, CFP®, CERTIFIED FINANCIAL PLANNER™, 585-419-0670 ext 50630 or email jterwilliger@cnbank.com.