Investment Tax Planning for Retirement: How to Make Taxes Work for the Client

By Chesser, Delton L.; Harrison, Walter T., Jr. et al. | Journal of Accountancy, August 2003 | Go to article overview
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Investment Tax Planning for Retirement: How to Make Taxes Work for the Client


Chesser, Delton L., Harrison, Walter T., Jr., Reichenstein, William R., Journal of Accountancy


EXECUTIVE SUMMARY

* FOR CLIENTS DREAMING OF A FINANCIALLY SECURE retirement, CPAs need to offer assistance on which savings vehicles--qualified and nonqualified--will help them reach their goal. This decision involves both tax and nontax considerations.

* CLIENTS PREPARING FOR RETIREMENT HAVE a wide variety of savings vehicles available to them including 401(k) plans, regular and Roth IRAs and other qualified plans. CPAs can recommend clients also set aside funds in other aftertax investment vehicles.

* IN RECOMMENDING RETIREMENT SAVINGS OPTIONS, CPAs have to keep in mind certain rules including minimum distribution requirements, premature withdrawal penalties and liquidity concerns.

* CLIENTS SHOULD CONTRIBUTE AS MUCH AS POSSIBLE on a pretax basis to their 401(k) plans, particularly those that offer employer matching, which immediately boosts the plan's "return." Clients over age 50 can make additional, catch-up contributions.

* THERE ARE SOME SAVINGS OPTIONS CPAs SHOULD encourage clients to avoid. These include tax-deferred annuities, which usually carry high fees, and nondeductible IRAs; a Roth IRA would be a better alternative.

As many Americans do, Sam and Sue dream of a stress-free retirement--enjoying an Alaskan cruise, visiting New York City or just strolling through the park. For this couple, tomorrow cannot come soon enough. Regrettably, for some retirees tomorrow may bring with it some disappointment.

Living one's retirement dreams requires much more savings and financial planning than most people realize. Today's prospective retirees are experiencing neither the increase in real income nor the corporate stability that past generations have enjoyed. Employers have shifted the risk of preparing for retirement to employees by replacing defined-benefit plans, which offer a guaranteed monthly retirement benefit, with defined-contribution and 401(k) plans, which are not guaranteed.

Couples such as Sam and Sue--and single individuals as well--realize they need help preparing for retirement and are turning to their CPAs for professional help. One question clients have is whether they should put their savings in tax-deferred or taxable accounts. They think tax-deferred investments would be better for them, but they don't fully understand the impact taxes will have on their retirement savings. And they worry about the liquidity of those funds and any related premature-withdrawal penalties. In addition they wonder what effect tax-rate changes after they retire will have on the savings vehicles they select today. This article answers these questions and provides a framework to help CPAs counsel clients like Sam and Sue on their choice of retirement savings vehicles.

ACCUMULATING ASSETS FOR RETIREMENT

CPAs can begin this process by identifying available savings vehicles. Clients have several options for accumulating retirement capital--among them taxable accounts, deductible pension plans, nondeductible IRAs and Roth IRAs. The various vehicles are best categorized by their tax treatment. Clients who understand the differences can make better decisions about how best to accumulate funds for their retirement. Most likely, they will use more than one vehicle to accomplish their goals.

Exhibit 1, page 66, summarizes the tax treatment of some of the more common savings vehicles. The tax consequences differ at inception, during the investment period and at withdrawal. At inception, the initial savings amount the clients place in a taxable account, a nondeductible IRA or a Roth IRA is made with aftertax dollars. Deductible pensions are funded with pretax dollars because these contributions escape current taxation.

During the investment period, the returns a taxable account generates are taxed annually at either ordinary income or capital gains rates. In contrast, returns are not taxed in deductible pensions, nondeductible IRAs or Roth IRAs.

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