New Tax Breaks: Choose Wisely

The big tax cut passed by Congress in May provides a legion of generous tax breaks for Americans with a specific savings goal in mind, such as education or retirement.

But is it too much of a good thing?

The menu of tax breaks is so appealing that it may tempt some people to overindulge by plowing more money than they should into 401(k) accounts, 529 college plans and other savings vehicles. Often, mutual funds are the investments of choice for these accounts.

The risk: Savers who later are forced to tap this money for other purposes--say, buying a house or starting a business--will be slammed with taxes and penalties that could overwhelm the tax breaks they sought in the first place.

“You really have to revisit what you’re investing for,” said Meloni Hallock, partner in the personal financial planning group at Ernst & Young in Los Angeles. “If you use the money for the intended purpose, these [tax-favored] accounts are great. But if you don’t, you would be better off investing your money elsewhere”--such as in a standard taxable account.

Consider, for example, 529 college savings plans. Investments made via these state-run plans grow tax-deferred, and starting in 2002 withdrawals will be tax free--if the money indeed is used to pay for schooling.

The catch: If the money is withdrawn for something other than education, profits earned in the account are subject to the contributor’s regular income tax rate plus a 10% penalty charge, said Joseph Hurley, author of “The Best Way to Save for College: A Complete Guide to 529 Plans” (BonaCom, 2001). That can wipe out the benefits and then some.

Other education savings plans--such as the education IRA--and most of the retirement savings plans that were boosted under the new tax law have similar penalties.

The one exception is the Roth IRA. Roth IRAs are set up to allow savers to make early withdrawals of more of their money before taxes and penalties kick in.

“If you’re not certain that you can leave the money alone, go for the Roth,” provided you meet the income qualifications, said Ed Slott, a New York certified public accountant and editor of Ed Slott’s IRA Advisor.

Here are some of the other enhanced opportunities for tax-deferred savings under the new law and the penalties for cashing out if you need the money prematurely or for something else.

* Allowable contributions to all types of retirement plans will rise over the next 10 years. Currently, investors can contribute $10,500 annually to a 401(k) or a 403(b) plan, $8,500 to a 457 plan--a type of defined-contribution retirement plan available to public employees--and $2,000 to an IRA.

Next year, those limits will rise to $11,000 for 401(k) and 403(b) plans, $11,000 for 457 plans and $3,000 for IRAs. Also, those age 50 and older will be able to make additional, “catch-up” contributions of $1,000 annually to company-sponsored retirement plans and $500 to IRAs.

The penalty for pre-retirement use of money in these plans depends on whether your contributions were tax-deductible. Generally, the withdrawal of earnings and any deductible contributions are subject to regular income taxes and the 10% penalty.

For instance, if you tap your 401(k) or 403(b) plan prematurely, you will typically owe taxes and the penalty on the entire amount you withdraw because all of your contributions were deductible. If you made nondeductible contributions to a traditional IRA, by contrast, you can escape paying the tax and penalty on the portion of the withdrawal that represents those after-tax contributions.

When penalties are imposed, the total bill can be steep: Note that some states, including California, impose penalties of their own. For middle-income taxpayers, that means you could pay 40 to 50 cents in total (federal and state) taxes for each $1 you pull out of the account.

For money saved in a 457 plan, you may not be able to get at it at all, said Nicholas Kaster, a pension expert at CCH Inc., a publisher of tax and pension information based in Riverwoods, Ill. Non-retired participants can withdraw money from 457 plans only if they no longer work for that employer, are age 70 1/2 or older, or have a serious and unforeseen economic emergency.

* Allowable contributions to education IRAs also were increased under the new law. Starting next year, you can contribute up to $2,000 per year to an education IRA, up from $500. Contributions aren’t tax-deductible, but the money is tax-free when it’s withdrawn, provided all the proceeds are used to finance school expenses.

If you pull out more from the account than you use on qualified education expenses, the profits are subject to income tax at your regular rate and you’re generally subject to a 10% tax penalty. The one exception: The penalty is waived if the reason you’re not using the IRA money is that you received a scholarship.

* The same penalties and penalty waivers apply to 529 education savings plans. Contribution limits on these plans are set by individual states that sponsor them, with some allowing you to save as much as $250,000 per student.

The bottom line for all of these plans: Don’t overlook the potential penalty risk of locking away too much of your money. You may not enjoy paying taxes each year on a conventional investment account, but once paid that money is yours free and clear.

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Higher Limits

The new tax law gradually raises the contribution limits for all types of tax-favored retirement plans. Those 50 and older can make additional, “catch-up” contributions too. Here’s how much you can save in the various plans now and in the future.

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Year 401(k) & 403(b) 457 plan IRA* 401(k), 403(b) IRA plan limits limits limits & 457 catch-up catch-up Current $10,500 $ 8,500 $2,000 $0 $0 2002 11,000 11,000 3,000 1,000 500 2003 12,000 12,000 3,000 2,000 500 2004 13,000 13,000 3,000 3,000 500 2005 14,000 14,000 4,000 4,000 500 2006 15,000 15,000 4,000 5,000 1,000 2007 ** ** 4,000 ** 1,000 2008 ** ** 5,000 ** 1,000 2009 ** ** ** ** 1,000 2010 ** ** ** ** 1,000

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* Includes Roth and regular individual retirement accounts.

** Contribution limits are adjusted annually for inflation, rising in increments of $500.

Source: Investment Company Institute