Consider tax benefits when investing retirement assets

Rick Imhoff, certified financial planner, is president and CEO of Sterling Trust in Springfield, a locally owned independent trust company.

Beginning Jan. 1, participants in 401(k), 403(b) and 457 plans will be able to save more for retirement. The contribution limits will increase by $1,000 to $13,000. For those participants over age 50, the catch-up contributions have also increased by $1,000 to $3,000. With the catch-up provisions, participants over age 50 can contribute up to $16,000 in their retirement plan.

These higher limits can greatly assist individuals in reaching their retirement goals.

But once those dollars are contributed to the plan, the participant must then decide how to invest the funds. With the new tax breaks on capital gains and dividends, the decision can be even more difficult.

Under the new tax law, taxpayers in the 25 percent or higher federal income tax bracket will only pay at a 15 percent tax rate on qualifying dividends and long-term capital gains. For taxpayers in the 10 percent or 15 percent tax, the rate is only 5 percent.

With this in mind, does it make more sense to invest retirement plan and IRA assets in taxable bonds and invest assets held outside of retirement plans and IRA's in equities?

The answer will depend on how much of the investor's total assets are inside and outside of a retirement plan and the investor's asset allocation strategy.

As an example, let's say Bill Smith has $100,000 in his 401(k) plan and $300,000 in a personal investment account and his asset allocation strategy is 75 percent equities and 25 percent fixed income. One consideration would be for Bill to invest the entire 401(k) plan account balance in fixed income securities and all of his personal investments in equities to meet his asset allocation strategy.

The benefits of this arrangement would be to defer taxation of the interest earned on the fixed income securities since earnings on 401(k) plan assets are not currently taxed.

Assuming an average 4 percent yield on his $100,000 account, Bill would keep $4,000 in interest from being taxed if the securities were held in his personal investment account. If Bill is in the 25 percent federal income tax bracket, he could potentially save $1,000 in income taxes.

By having his equities in his personal investment account, Bill can take advantage of the 15 percent tax rate on capital gains and qualifying dividends. In addition, if one of Bill's equity selections did not fair well, he could sell it and take the loss on this tax return. These benefits would not be available to Bill if his equity investments were in his 401(k) plan. Fixed income securities typically do not generate much in the way of capital gains or losses, as compared to equities.

In addition, interest earned on fixed income securities do not qualify as dividends and the special 5 percent or 15 percent tax rate.

In another example, let's say Sue Jones has $200,000 in her 401(k) plan and $200,000 in a personal investment account and her asset allocation strategy is the same as Bill's.

She could consider investing half of her 401(k) plan assets in fixed income securities and the other half in equities. Her personal investment account would be invested 100 percent in equities. As with Bill, Sue would be able to invest all of her fixed income securities in her 401(k) plan and have a more favorable tax treatment on her earnings.

This division of assets among retirement plans and personal investment accounts is not necessarily recommended for everyone.

Each individual investor has different financial goals, investment objectives and risk tolerance that must be considered when developing a proper asset allocation strategy.

The bottom line is to take advantage of all the tax benefits available and to maximize your after-tax return.