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Break Dancing : Knowing the Right Moves in Tax-Favored Investing Can Make a Big Difference

10 Things Every Investor Needs to Know: 7. How to use tax breaks

December 17, 1996|KATHY M. KRISTOF

There's an old adage in finance: "It's not what you make, it's what you keep."

That thought is behind a number of investment vehicles that allow you to defer income taxes on earnings or to avoid taxes entirely. And that allows you to earn compound investment returns on Uncle Sam's dime.

Consider an investor, Sam Smart, who puts $100 a month into mutual funds in his 401(k) plan--a tax-deferred retirement account--and earns a 10% average annual return over the course of 40 years. At retirement, he has $632,408.

His friend Sue Savvy invests in a taxable mutual fund instead and pays income tax from her fund account each year. Even though Savvy invests the same amount and earns the same investment return as Smart, she accumulates much less--just $277,694. (To simplify matters, we've assumed that the fund has realized 100% of its capital gains and she pays federal income tax on all of it at a 28% rate. In reality, most mutual funds would defer at least some gains, and individual tax consequences can vary.)

When Savvy retires, she doesn't have to worry much about taxes. Smart, on the other hand, must pay tax on the 401(k) when he withdraws the money at retirement.

If he takes the money out in one lump sum, he'll push himself into the highest marginal tax bracket, but he'd still end up with about $380,000 after surrendering 39.6% of his savings in federal income taxes.

If, in a more likely scenario, he takes money out over time, the money withdrawn from the 401(k) will be taxed at a more modest rate. In any event, Smart is somewhere between $100,000 and $200,000 (depending on his tax rate) richer than Savvy simply because he was able to collect investment returns--and allow them to compound year after year--on money that otherwise would have been paid to the government.

Which is all to say: Tax-favored compounding is a powerful force. Just how powerful it will be depends on other considerations.

Tax rates much higher--or lower--at retirement will reduce--or multiply--Sam Smart's advantage. Unrelated capital losses might reduce the taxes on gains Sue Savvy would pay along the way. And tax law changes are, of course, unpredictable.

Here are the pros and cons of the major options for tax-deferred investing--retirement accounts, annuities and growth stocks--and the pros and cons of municipal bonds, which offer outright tax avoidance on their interest:

* Retirement accounts. Generally speaking, retirement accounts have two major advantages: Contributions are tax-deductible, so, as an incentive for saving, you pay less current income tax. In addition, investment income earned in your retirement account is not taxed until you start to withdraw it.

But there are two major disadvantages: When you withdraw the money, every dollar--including your principal--counts as taxable income (assuming you got the deductions upfront as you contributed). And withdrawals are taxable at your ordinary income tax rate, which may be higher than the capital gains rates that might otherwise apply to long-term investment gains.

In addition, if you take your money out before retirement, you'll get hit with penalties--hefty ones. The federal government generally imposes a 10% tax penalty on retirement funds withdrawn before age 59 1/2. And many states, California among them, impose their own. California's penalty amounts to 2.5% of the withdrawn amount.

There are a variety of tax-deferred retirement accounts offered to different groups of people and subject to different rules and regulations. For example, there are Keogh plans for self-employed individuals; individual retirement accounts, or IRAs; 403(b) plans for teachers and employees of nonprofit organizations; and so-called 457 plans for government workers.

And, of course, there is the 401(k), one of the more flexible and attractive retirement plans around. The vast majority of large employers offer these company-sponsored retirement programs. They allow workers to set aside up to $9,500 of their wages annually if their company program rules allow it, and to deduct this amount from their taxable earnings. Someone contributing $9,500 would reduce his or her annual tax bite by $2,660 if that person was in the 28% federal bracket. (You'd save on state income taxes too.)

Investment options for contributed savings differ by plan, but generally you are able to choose among company stock, mutual funds and simple savings accounts. Investment gains and dividend income that accumulate in the account are also exempt from income tax until the money is withdrawn.

But what really differentiates these accounts from other tax-favored investment options is that most employers will match worker contributions, kicking in 25 cents to 50 cents for every dollar saved by the employee. That supercharges the returns, making it far easier to save a substantial sum.

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