Q: Clearly, the key provisions in the 2003 tax law are the rate cuts on investment income. [Dividend income will be taxed at no more than 15%, down from rates ranging from 27% to 38.6%. Long-term capital gains also face a top rate of 15%, down from 20%.] How should those cuts affect where you put your savings?
A: The advantages of saving in a tax-deferred account have been sharply reduced. If you have a choice between putting money in, say, a non-deductible IRA [Individual Retirement Account] or a taxable account, the taxable account may be a better choice now. You'll pay 15% tax on the earnings every year. But that can be a better deal than putting off the tax and paying 35% at withdrawal. [Earnings in tax-deferred accounts are taxed as ordinary income. The new top rate for ordinary income in the 2003 law is 35%.]
Every Jan. 2, my wife, Nina, and I both max out on our annual contributions to our non-deductible IRAs ($3,500 apiece in 2003). Next January, we might not do that.
Q: There's a range of tax-deferred savings accounts, with various provisions. Can we sort out which ones are affected most?
A: The ones most clearly hurt are non-deductible IRAs, after-tax contributions to 401(k)s, and variable annuities [insurance policies that defer taxes]. If you're high-bracket taxpayer and you don't get a tax deduction on the money you contribute, this new law says that you should think twice about using that.
These accounts all have other disadvantages -- you don't get stepped-up basis at death [which relieves heirs of paying tax on accrued capital gains on inherited assets] and you've got penalties for withdrawing before age 59 1/2. With a taxable account, you don't have those problems.
At the other end are accounts where you do get a deduction and you're saving pretax dollars. That's still an advantage for pretax 401(k)s -- especially with an employer match -- and deductible IRAs.
One case that will take a lot of study is deferred executive compensation. If your company offers it, you can save pretax dollars and defer taxes on the earnings. So it has those advantages -- but with the new rates, the advantage is less. And deferred compensation is subject to the claims of a company's creditors, if your employer runs into trouble. So you're subject to the investment risk of how your company invests your comp, and the additional risk of your company going bankrupt.
Q: Should people be cashing money out of an IRA to put it in taxable accounts?
A: There's a 10% penalty for cashing out an IRA before age 59 1/2, in most cases. So pre-retirement, that doesn't work.
If you're in your 70s or 80s and you have a lot of money in an IRA or 401(k), you might want to look at that. Cashing out lets you avoid the complexities of required distributions [mandatory withdrawals that start at age 70 1/2]. And a taxable account is certainly more flexible for your heirs. So the older you are, or the worse your health, the more you might consider cashing out.
Q: Any other good strategies?
A: If you're in the 10% or 15% tax brackets, your capital-gains and dividend rate is going down to 5% -- it'll be zero in 2008, but even 5% is awfully close to zero. So there's a huge benefit in transferring stocks, both appreciated growth stocks and dividend stocks, to your children over 13, who are likely to be in those brackets. [Taxpayers with taxable incomes of $14,000 or less are in the 10% bracket; income between $14,000 and $47,450 is taxed at 15%.] A couple can transfer $20,000 a year to each child and have the profits taxed at 5% instead of 15%. That's a big gain.