Tax
Cuts Versus Tax Deferral
In 2004, contribution limits for many employer-sponsored retirement plans will jump from
$14,000 to $16,000 for those aged 50 and older. But just because you can
contribute more doesn’t necessarily mean you should.
Because current income taxes on contributions to these types of plans are
typically deferred until the money is withdrawn in retirement, many people have
taken advantage of the higher contribution limits.1
But recent changes to the federal tax law may prompt some of these same people
to reexamine their retirement savings strategies.
Dividends Versus Interest Income
The 2003 tax law created an important tax distinction between stock dividends
and interest income. Qualified corporate dividends are now taxed at a maximum
rate of 15 percent for most investors. Previously, dividends were taxed as
ordinary income, which could reach a high of 38.6 percent (now 35 percent).
Unfortunately, some dividends do not qualify. Real estate investment trusts and
dividends paid by money market mutual funds are considered to be interest
income, which continues to be taxed at ordinary income tax rates. Instruments
such as bank accounts, CDs, and bonds also pay interest income and do not
qualify for the reduced rate. And dividends from investments held in
tax-deferred accounts aren’t eligible either; all funds held in deferred plans
are taxed as ordinary income when withdrawn.
The difference between paying a 15 percent dividend tax rate now or ordinary
income taxes in retirement may influence the way some people allocate their
portfolios between taxable and tax-deferred accounts. Yet, depending on
individual goals and circumstances, some investors may elect not to adjust their
portfolios in response to the new law because they believe that the advantages
of tax deferral outweigh any potential (and temporary) change in tax
consequences.
End in Sight?
The special tax treatment of dividends is retroactive to January 1, 2003, but
will expire on December 31, 2008. Unless Congress extends this provision, stock
dividends will again be taxed at ordinary income tax rates beginning in 2009.
For this reason, it is important to consult a tax professional to determine how
the favorable tax treatment on dividends could affect your investment portfolio.
This may involve a careful evaluation of your time horizon, personal goals, risk
tolerance, and financial situation.
1) Distributions from most
employer-sponsored retirement plans are taxed as ordinary income and, if taken
prior to reaching age 59½, may be subject to an additional 10 percent federal
income tax penalty. Withdrawals must begin by April 1 of the year after the year
in which you reach age 70½.
© 2003
Emerald Publications
