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

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If, in a more likely scenario, he takes money out over time, the money withdrawn from the 401(k) will be taxed at a more modest rate.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.

Equally attractive is the fact that many companies allow workers to borrow as much as $50,000 or 50% of their 401(k) savings, whichever is less, to finance anything from a home purchase to a college education. This reduces the need to make actual withdrawals (which would incur penalties). Other retirement plans don’t offer savers this kind of flexibility.

If you can’t borrow from your retirement plan, it is worth considering how much money you can put away for the long term. If there’s a possibility that the money will be needed before you retire, you’d be wise to calculate when potential tax penalties outweigh the rewards of investing through such accounts. (See work sheet, D7.)

* Tax-deferred annuities. Like standard retirement accounts, annuities are essentially “shells” through which you can invest in securities such as stocks and bonds, deferring taxes on earnings until you begin withdrawing the money at retirement.

But unlike standard retirement accounts, the money you contribute to an annuity is not tax-deductible.

What’s more, if you pull money out before retirement, you’ll get hit with federal and state tax penalties, and possibly others. If you pull the money out before your annuity contract allows it, you may also get hit with a so-called surrender fee from the insurer.

On the bright side, annuities get their special tax treatment because they’re “wrapped” with a life insurance policy. But the cost of the insurance policy boosts the annual fees imposed on your annuity account, and that depresses your total return.

An annuity is not necessarily a bad idea if you need life insurance anyway, but it can be very difficult to figure out if you are getting a good deal when investments and insurance are wrapped together. A telling sign is that few fee-only financial advisors recommend annuities except in unusual cases. More commission-based planners recommend them, possibly because the companies offering them pay healthy commissions to the planners who sell them.

* Growth stocks. Another tax-favored investment alternative is to buy and hold stock in companies that grow and appreciate. What will that get you? Until you sell, you won’t have to pay tax on the stock’s price appreciation.

Let’s say you put $100 a month into the stock of a fast-growing company, and the stock appreciates at a 10% average annual rate. At the end of the 40th year, you’ll have stock worth $632,408--just as much as Sam Smart with his 401(k).

Sam pays taxes on his 401(k) withdrawals at his current ordinary federal tax rate--possibly as high as 39.6% today--but you would pay a maximum of 28% of your accumulated gains in federal taxes, because 28% is the top rate for long-term capital gains. Subtracting your principal investment of $48,000 made over the 40 years, if you sold your stock worth $632,408, you’d pay $163,634 in federal capital gains taxes, leaving you with $468,774.

That’s more than Sam Smart ends up with, unless he is at a very low tax bracket at retirement. And if you end up leaving money to charity or heirs, there are significant tax advantages to giving appreciated stock rather than trying to give away 401(k) funds. On the other hand, Smart got upfront tax deductions that you didn’t get when investing directly in stocks. And if he got matching funds from his employer, he probably ended up ahead.

* Municipal bonds. These bonds, debt issued by cities, states and counties, pay interest that is tax free to residents of the state in which the bonds are issued.

If you are in the highest federal and state tax brackets, municipal bonds can be a good bet. Although they pay relatively low rates of interest, all the interest earnings are free from federal and state income taxes.

What does that mean in dollars and cents? If you are in the 39.6% federal bracket and the 9% California bracket, you pay about 45% of your investment earnings in income taxes. (State taxes are deductible on your federal return, so you can’t simply add the tax rates.) If you invest $100,000 in a taxable bond paying a yield of 8%, for annual interest of $8,000, you’d give up about $3,600 of that in taxes. In the end, you’d take home just $4,400.

If, on the other hand, you invest that $100,000 in a 5% tax-free municipal bond, the entire $5,000 in annual interest is yours to keep. In the end, you’re better off to the tune of $600.

Still, municipal bonds--bought individually or through mutual funds--generally make sense only for people in the highest tax brackets. If in doubt whether they’re right for you, consult a financial advisor.

Next lesson: How to keep good records

Kathy M. Kristof writes about personal finance. She can be reached via e-mail at kathy.kristof@latimes.com, or write to Personal Finance, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.

Extra Credit

To access previous Investing 101 columns, go to https://www.latimes.com/invest101

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Finding Break-Even Point

Generally, you are better off saving in after-tax investments than pretax investments if you think you will need the money within a few years.

But how many years, exactly? Well, it helps to do the math.

Let’s say, for example, that you can afford to save $100 a month of your after-tax income and you’re in the 28% federal tax bracket. Because that $1,200 annual individual retirement account contribution will save you $336 in current-year income taxes, you can contribute $1,536--the $1,200 that you’d planned, plus the $336 tax benefit--annually and still be left with the same amount of disposable income. (Actually, to split hairs, your cash flow will be a bit better because you also get a tax break on the $336.)

Thus, it’s $1,536 in the IRA versus $1,200 in the taxable account.

However, remember that if you pull money out of the IRA before retirement, all of it--principal and interest--will be taxed at your ordinary income tax rate and subject to penalties.

If you invest through a tax-favored 401(k) retirement plan, make sure you account for any matching employer contributions, which can quickly make tax penalties insignificant if you must take out money later. Also note that some companies require that you meet a “hardship test” before making a withdrawal.

The following work sheet can serve as a basis for doing this analysis. If you have a present-value calculator, you can do it with fewer steps. To simplify the analysis, we’ve dealt only with the impact of federal income taxes.

1. How much of your after-tax earnings can you afford to save each year?

$

2. Multiply the answer on line 1 by your marginal federal tax rate. (In other words, if you put $1,000 on line 1 and pay 28% of your income in federal tax, multiply $1,000 by 28%, or 0.28, to get $280.) Enter the result here:

$

3. If your employer offers matching contributions, enter the amount of the employer match here: $

4. Add lines 1, 2 and 3 for your total retirement plan investment:

$

5. Estimate an average investment return. (You have to guess. Stocks have returned 10.5% on average for the last 70 years, but may not do the same in the next 10. Bonds and banks pay closer to 6% to 8%.)

Estimated annual return: %

6. Multiply your estimated rate of return by your total investment in both the taxable and tax-favored account. Your total investment in a taxable account would be the number recorded on line 1. Your total investment in a tax-favored account would be the result on line 4. Enter the results here:

a) (No. 1 x No. 5) Investment return, taxable account: $

b) (No. 4 x No. 5) Investment return, tax-favored account: $

7. Determine your total account value at the end of the first year by adding these returns to your original investment. In other words, add the result on 6a to the result on line 1 to get the value of your taxable account. Add the result of 6b to the result on line 4 to get the value of your tax-favored account.

a) (No. 6a + No. 1) Year-one value, taxable account: $

b) (No. 6b + No. 4) Year-one value, tax-favored account: $

8. Assess the tax impact if you sold. For the taxable account, you would multiply the investment return by your marginal tax rate or your capital gains rate (if you held the investment for a full year or more), whichever is lower.

For the nontaxable investment, add 10 percentage points to your marginal federal tax rate and multiply the result by the total amount on line 7b. In other words, if you are in the 28% federal tax bracket, determine the tax impact by multiplying your total account value by 38%.

a) Tax cost of selling, taxable account: $

b) Tax cost of selling, tax-favored account: $

9. Subtract the tax cost of selling from the respective total account values. The result shows which account would net you a better return after the first year.

a) Cash-out value, taxable: $

b) Cash-out value, tax-deferred: $

If you don’t anticipate selling in the first year, add your second-year contributions to your total account values listed on line 7. Multiply the results by your estimated annual return, add the respective returns, and assess the tax impact explained in line 8. Or you can repeat this for several years and then assess the tax impact to find the year when the tax-deferred account ends up larger than the taxable account. (This is where a present-value calculator would be handy.)

--KATHY M. KRISTOF