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Are retirement plans obsolete? Don’t believe the myth

by on
in Small Business Tax,Small Business Tax Deduction Strategies

The 2003 tax law spawned dozens of great tax strategies, plus a couple of duds.

One lame concept gaining traction these days: Reduced individual income tax rates make your tax-deferred retirement plan an inferior retirement savings vehicle. Instead, the story goes, you should stash your retirement money in a taxable account at your friendly brokerage firm.

Our take: That's nonsense. But before we make our case, let's first understand the reasoning behind that misguided notion.

Theory: Use taxable account for retirement

First, due to lower tax rates, your federal income tax deductions for retirement account contributions are worth less than before. Second, dividends and long-term capital gains earned inside a tax-deferred retirement account won't qualify for the new 15 percent maximum rate. Instead, they're taxed at your higher ordinary income rate (up to 35 percent) when you begin draining the account. Also true.

So that theory says today's best retirement savings strategy is to load up on common stocks and stock mutual funds in your taxable brokerage accounts. That lets you take full take advantage of the new 15 percent maximum rate.

Debunking the theory

While elements of truth exist in that idea, the theory is plain wrong! Let's run a scenario to prove it. First, we'll make some assumptions to generate the numbers:

• Assume common stocks and mutual funds return 8 percent annually before taxes. Assume 5 percent return comes from long-term gains. The remaining 3 percent comes from dividends. So the entire 8 percent return gets taxed at 15 percent.

• You have 15 years until retirement.

• Over those 15 years, your combined marginal federal and state tax rate on ordinary income is 42 percent (35 percent federal plus 7 percent state).

• Until retirement, your combined federal and state tax rate on long-term gains and dividends is 20 percent annually
(15 percent federal + 5 percent state).

• When you start dipping into your retirement fund in 15 years, your marginal tax rate on ordinary income is 33 percent (28 percent federal plus 5 percent state).

Using tax-deferred retirement account. Under those assumptions, say you make a $20,000 deductible contribution to your tax-deferred retirement account. It grows to an after-tax amount of $42,507 after 15 years ($20,000 invested for 15 years at 8 percent annual return with 33 percent lost to retirement-age income taxes).

But there's more! We also assume you'll invest the $8,400 tax savings from the deductible contribution ($20,000 times
42 percent) in a taxable account. That $8,400 will grow to $21,301 after taxes ($8,400 invested for 15 years at 6.4 percent annual after-tax return [.80 x 8 percent]).

Final tally: Your retirement stash grows to a robust $63,808 after paying all taxes ($42,507 plus $21,301). Remember: This is from just one year's contribution.

Using taxable brokerage account. If you follow the wrong-headed strategy of dumping your retirement funds in a taxable brokerage account, your $20,000 investment grows to only $50,717 after taxes ($20,000 invested for 15 years at 6.4 percent annual after-tax return [80 x 8 percent]).

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