Tax is a pretty broad area of the law. I don’t profess to know it all. Okay, my brothers may say that I think I do, but that’s just for their benefit (and to keep them in their place). I really don’t.
One of the subjects which I will freely admit is one of my weaknesses is retirement planning and tax. I know enough to be dangerous but clearly, I’m no expert. Fortunately, I’ve always surrounded myself with other folks who know what they’re talking about (hey lawyer newbies, this is key!).
One of those experts, Ed Garrison, has been kind enough to pen a guest post for taxgirl on “Tax Considerations in Retirement Investing.” Ed is the Executive Director of AAFR, the American Association of Future Retirees. His article will appear today and tomorrow as part of a series.
So enjoy…
Tax Considerations in Retirement Planning
Many people consider the tax side of retirement investing to be a no-brainer: invest as much as you can in tax-deferred accounts (like 401k’s or IRAs), and your money will compound tax-free. Period.
Believe it or not, however, a tax-deferred account is not always the ideal place for retirement investments. In some cases, it can even end up increasing your tax burden!
Some Investments Are Already Tax-Favored
What possible reason can there be not to use a tax-deferred account (other than the fact that you generally can’t withdraw your money without penalty until you’re 59 1/2 years old)? The problem lies in the tax treatment of the withdrawals. These are generally treated as ordinary income (Roth IRAs are an exception). Because of this, they incur the maximum possible income tax. That’s not a problem if the income generated by your investments would have been ordinary income anyway. But if not, you’ll lose the tax advantages you would otherwise have had, and instead end up paying the top tax rate.
The two most common examples of this are long-term capital gains and dividends. In most cases, these forms of income are taxed at a maximum of 15%. By contrast, the highest marginal tax rate on ordinary income is 35%, or more than double the reduced rate. Like other income, the dividends and capital gains you rack up in your tax-deferred account won’t be taxed when you receive them. But when you go to withdraw your money, if you’re in the top tax bracket, you’ll pay 35%. Investments that generate most of their returns through capital gains and dividends, therefore, may be more profitable if you keep them in an ordinary, taxable account.
Also, any investment vehicle that’s already tax-free or tax-deferred absolutely, positively, does not belong in a tax-deferred account. If you hold, for example, municipal bonds or variable annuities in your IRA, you’ll eventually pay taxes you otherwise wouldn’t have owed at all!
Why do people do this? Some do it out of ignorance; but in most cases, they’ve been talked into such absurd investments by unscrupulous investment advisors. Variable annuities–especially those sold by salespersons–are loaded down with all kinds of fees and commissions, making them very lucrative for the sellers. Some salespeople can’t resist the easy money, and (unethically) push them even for tax-favored accounts. If this happens to you, you should find another advisor immediately, and probably lodge a complaint with your state’s regulatory authorities.
For more on Tax Considerations in Retirement Planning, check out Part 2 tomorrow – and stop by Ed’s blog.
Dear Tax Girl,
No offense but you do not understand finance well enough to make such a strong recommendation that Variable annuities do not belong in IRA’s. Just to give you a few examples, annuities in IRA’s provide living protection and death benefit protection for your IRA, eliminate the prospect of a step down in basis (guaranteed death benefit) and finally if owned in a Roth can provide income for life TAX FREE. An IRA is a someone’s largest asset and since ERISA has decimated the defined benefit plan clients must have an income stream that they cannot outlive in retirement. By the way you don’t pay any extra for tax deferral if you own it inside an IRA.
This generation of annuities is not your grampa’s! Please work with an investment professional. They can educate you on further estate planning usage of VA’s such as owned in the B trust etc…
eliminate STep down in basis if owned in a roth
Dennis,
Thanks for the comments. I noted in my post that retirement planning IS NOT one of my areas of expertise. This is a guest post written by Ed Garrison. I’ll let Ed respond to your comment directly.
Dennis–
I consider variable annuities to be a bad choice for tax-deferred accounts because of the high costs involved, including the cost of the insurance component. If you’ve already maxed out other tax-deferred options (IRA, 401k) and feel that you must create an additional tax-deferred account, then you may decide to bite the bullet and accept the high charges as the price you pay for the tax deferral. You can reduce the cost by avoiding advisors/salespersons and buying the annuity directly from an issuer like Vanguard.
Otherwise, if you want a death benefit, you’re better off shopping around for life insurance and buying the most economical policy possible in the normal manner. If you want income, then invest your IRA money in an appropriate no-load fund such as a Ginnie Mae fund–and schedule your withdrawals in such a way that your account does not meet its demise before you do.
I’m well aware that commission-based advisors HATE this advice. Variable annuities are very lucrative for them because they’re loaded down with so many fees–up front, at surrender, and along the way–a portion of which go directly into their pockets. But from the consumer’s point of view, every penny of these fees is one penny (plus interest/dividends) less that will be available for retirement.
… but that’s only my personal viewpoint. If you’re a fan of variable annuities, simply because you see things differently, or perhaps because you’re in the business yourself, you’re certainly entitled to your opinion.
Ed Garrison
Executive Director
AAFR | American Association of Future Retirees
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job.