Don't Stop Stuffing Your 401(k) Yet
President Bush's plan to repeal the individual tax on dividends has sent investors and financial planners scrambling for their calculators. One key question on everyone's mind: If the plan becomes law, should investors bother to keep putting money into 401(k)s, individual retirement accounts, and other tax-advantaged savings plans?
The answer--for most people--is yes, according to mutual-fund giant T. Rowe Price Group Inc. But once they have maxed out their 401(k)s, some individuals may be better off putting their hard-earned dollars into taxable accounts rather than into more esoteric aftertax investments, such as variable annuities.
Price concluded that most workers should continue to put pretax dollars into IRAs and 401(k)s. Whether you are investing in growth funds, which throw off few dividends, or income funds, which generate almost one-third of their total return through corporate payouts, you still would be in better shape sticking with those tax-advantaged accounts.
The reason: You'll be able to make a greater initial investment because your dollars are contributed before taxes. Here's how the numbers work, assuming you earn an average of 8% a year. Put $10,000 into a 401(k) equity-income fund, and after 20 years, you'll have $32,324. That's before any company match. But if you don't make a pretax contribution with the dough, you'll first have to pay federal and state income taxes on the $10,000. That will leave you with only about $6,900 to invest. After 20 years, your nest egg will be just over $26,000.
However, the Bush plan may require new thinking about investing with aftertax dollars. If the proposal becomes law, you may be far smarter to throw extra cash into a taxable account rather than into a sheltered investment such as a variable annuity or a nondeductible IRA, where the benefit of tax-free dividends is lost. For example, on a $10,000 investment, Price figured the tax-deferred account would be worth just $35,389 after 20 years, assuming taxes are paid at ordinary income rates when the cash is distributed. A taxable account would be valued at $37,668, since there's no tax on the dividends.
The Price study is rough, and it ignores two key provisions of the Bush plan. Price assumes all dividends would be tax-free. But Bush would curb a company's ability to pay tax-free dividends unless it first pays corporate taxes on its earnings. This rule would make taxable accounts less attractive.
On the other hand, the Bush plan also would give investors a big capital-gains tax break for shares in companies that retain and reinvest earnings. That would boost the taxable accounts. Still, the lack of details made it impossible to figure how big a benefit that would produce.
So for now, keep doing what you've been doing. If you are participating in a 401(k), don't stop. Key details of the Bush plan will change as Congress debates the bill. But when it finally passes, take stock of what it means for your tax-advantaged accounts.
By Howard Gleckman in Washington