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Practical Advice from a Tax Planner

Bernard Kent, partner in PricewaterhouseCooper's personal finance practice in Detroit, has been analyzing the new tax law's impact on savings and investment strategies. He spoke recently with BusinessWeek Senior Correspondent Mike McNamee about how investors should adjust (click here to see a video interview with BW's Mike McNamee on the subject of the tax plan's impact). Here are edited excerpts from their conversation:

Q: Clearly, the key provisions in the 2003 tax law are the rate cuts on investment income. [Dividend income will be taxed at no more than 15%, down from rates ranging from 27% to 38.6%. Long-term capital gains also face a top rate of 15%, down from 20%.] How should those cuts affect where you put your savings?

A: The advantages of saving in a tax-deferred account have been sharply reduced. If you have a choice between putting money in, say, a non-deductible IRA [Individual Retirement Account] or a taxable account, the taxable account may be a better choice now. You'll pay 15% tax on the earnings every year. But that can be a better deal than putting off the tax and paying 35% at withdrawal. [Earnings in tax-deferred accounts are taxed as ordinary income. The new top rate for ordinary income in the 2003 law is 35%.]

Every Jan. 2, my wife, Nina, and I both max out on our annual contributions to our non-deductible IRAs ($3,500 apiece in 2003). Next January, we might not do that.

Q: There's a range of tax-deferred savings accounts, with various provisions. Can we sort out which ones are affected most?

A: The ones most clearly hurt are non-deductible IRAs, after-tax contributions to 401(k)s, and variable annuities [insurance policies that defer taxes]. If you're high-bracket taxpayer and you don't get a tax deduction on the money you contribute, this new law says that you should think twice about using that.

These accounts all have other disadvantages -- you don't get stepped-up basis at death [which relieves heirs of paying tax on accrued capital gains on inherited assets] and you've got penalties for withdrawing before age 59 1/2. With a taxable account, you don't have those problems.

At the other end are accounts where you do get a deduction and you're saving pretax dollars. That's still an advantage for pretax 401(k)s -- especially with an employer match -- and deductible IRAs.

One case that will take a lot of study is deferred executive compensation. If your company offers it, you can save pretax dollars and defer taxes on the earnings. So it has those advantages -- but with the new rates, the advantage is less. And deferred compensation is subject to the claims of a company's creditors, if your employer runs into trouble. So you're subject to the investment risk of how your company invests your comp, and the additional risk of your company going bankrupt.

Q: Should people be cashing money out of an IRA to put it in taxable accounts?

A: There's a 10% penalty for cashing out an IRA before age 59 1/2, in most cases. So pre-retirement, that doesn't work.

If you're in your 70s or 80s and you have a lot of money in an IRA or 401(k), you might want to look at that. Cashing out lets you avoid the complexities of required distributions [mandatory withdrawals that start at age 70 1/2]. And a taxable account is certainly more flexible for your heirs. So the older you are, or the worse your health, the more you might consider cashing out.

Q: Any other good strategies?

A: If you're in the 10% or 15% tax brackets, your capital-gains and dividend rate is going down to 5% -- it'll be zero in 2008, but even 5% is awfully close to zero. So there's a huge benefit in transferring stocks, both appreciated growth stocks and dividend stocks, to your children over 13, who are likely to be in those brackets. [Taxpayers with taxable incomes of $14,000 or less are in the 10% bracket; income between $14,000 and $47,450 is taxed at 15%.] A couple can transfer $20,000 a year to each child and have the profits taxed at 5% instead of 15%. That's a big gain.

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