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84 Taxes 27 (2006)
When Should Investments in Equities Earmarked for Retirement be Placed in Taxable Accounts Instead of Retirement Accounts

handle is hein.journals/taxtm84 and id is 719 raw text is: August 2006 When Should Investments in Equities Earmarked for Retirement Be Placed in Taxable Accounts Instead of Retirement Accounts? By Richard B. Toolson and Caroline K. Craig Richard B. Toolson and Caroline K Craig examine when it is prudent for an individual to invest equities outside of a 401(k) or 403(b) plan. ver the last several years, the contribution limits for retirement plans have expanded significantly. Currently, for 2006, an em- ployee may elect to defer a maximum of $15,000 on a pre-tax basis (indexed in later years) under either a Code Sec. 401 (k) or 403(b) retirement plan.' More- over, individuals who are at least 50 years of age by the end of the year may make catch-up contribu- tions (if their plans permit) of up to $5,000 for 2006, with inflation adjustments in later years.2 Beginning in 2006, a Code Sec. 401 (k) or Code Sec. 403(b) plan may allow participants to have some or all of their elective deferrals treated as Roth IRA contributions under Code Sec. 402(A).3 Given these generous maximum limits, the vast majority of participants never have to worry about exceeding these limits and being forced to invest in taxable accounts (or IRAs, if eligible). As far back as 2001, when the contribution limits were consider- ably lower, only 5.6 percent of 401 (k) participants made the maximum allowable contribution.4 This article will examine when, if ever, it might be pru- dent for an individual to invest equities outside of a 401 (k) or 403(b) plan even though he or she does not exceed retirement plan contribution limits. Assuming comparable before-tax rates of return, Richard B. Toolson, Ph.D., CPA, is a Professor in the School of Accounting, Information Systems and Business Law at Washington State University in Pullman. Caroline K. Craig, Ph.D., CPA, is a Professor in the Department of Accounting at Illinois State University in Normal. the decision to invest funds inside or outside a retirement plan should depend on the relative tax efficiency and other costs for the different alterna- tives. Detailed examples comparing the after-tax returns and effective tax rates for retirement plans versus tax-efficient, tax-inefficient and so-called tax-aware portfolios are discussed. For the majority of 401(k) and 403(b) plans, em- ployees are offered some type of employer-matching contribution. Often, the employer contributes $0.50 for every dollar contributed by the employee on the first six percent of salary. Since any matching amount effectively yields an immediate profit on the employ- ee's contributed amount, it almost always makes sense for the employee to make a contribution that is at least sufficient to receive the entire employer- matching amount. It will therefore be assumed, in examining when it might make sense to alternatively invest outside an employer-sponsored plan, that no matching funds are provided by the employer. It is also assumed that the employee has not reached his or her contribution limit and consequently has a choice of whether or not to contribute equities to an employer-sponsored retirement plan. How Tax Efficient Are Retirement Plans? In general, contributions to an employer-sponsored plan are immediately tax deductible (made with before-tax dollars) and earnings within the plan are not subject to taxation as long as no funds are 02006 R.B. Toolson and C.K. Craig TAXES-THE TAx MAGAZINE 27