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After-Tax Accounts: An Important Piece of the Investment Puzzle

J Terwilliger 2014
James P. Terwilliger, PhD, CFP®
Senior Vice President, Senior Planning Advisor
[email protected]
(585) 419-0670 x50630

Much has been written about the benefits of retirement savings vehicles – 401(k)s, 403(b)s, IRAs, Roth IRAs, and other tax-advantaged savings plans.

Such vehicles provide a number of benefits. Most offer tax deferral on contributions and on earnings/growth and, for some, the added bonus of an employer match. The Roth IRA and Roth 401(k) have no upfront tax deduction for contributions but offer tax-free earnings/growth. Additionally, because of these benefits, millions of workers, who otherwise might not be saving for retirement, are responsibly saving on a regular basis.

However, the truth for many folks approaching retirement is that a combination of 401(k)/IRA/Roth IRA accounts plus Social Security benefits may not provide enough to fund a comfortable retirement. Where will the rest come from? While a purchased immediate fixed annuity is one option, there is another option that is more flexible and perhaps more attractive from an income tax perspective – after-tax savings and investment accounts.

While it is true that after-tax accounts do not offer upfront tax deductions/credits or tax-deferred growth (or Roth-related tax-free growth), they do offer a number of advantages. These advantages make after-tax accounts attractive complements to standard retirement plans:

  • No contribution limits – Standard retirement plans have a maximum annual contribution cap. 401(k) plans this year, for example, are capped at $17,500 plus $5,500 additional for participants age 50 or older. IRAs and Roth IRAs are capped at $5,500 plus $1,000 additional for age 50 or older. After-tax accounts have no contribution limit.
  • No income limits – Most tax-advantaged plans have income limits. Employer plans limit the degree of participation for workers with high incomes through anti-discrimination rules. IRAs and Roth IRAs impose income caps which prohibit contributions for years in which the caps are exceeded, although non-deductible IRA contributions are not subject to an income limit. An after-tax account is available to anyone, regardless of income.
  • Easy access to funds – Unlike employer retirement plans, after-tax accounts are not burdened by restrictive loan or hardship withdrawal provisions. And, unlike most tax-advantaged plans, they do not involve 10% early withdrawal penalties. Account holders can get at their money when they need or want it.
  • Investment flexibility – Participants in employer retirement plans are limited to the investment choices chosen by their employers. Also, many IRA and Roth IRA investment choices are limited by the account administrator. With a taxable account, investment choices are unlimited.
  • Tax flexibility – Regular after-tax accounts have a big advantage over tax-deferred retirement accounts: long-term capital gains and most stock dividends are currently taxed by the IRS at low maximum rates – 0% (for 10% and 15% marginal tax brackets), 15% (for 25%-35% tax brackets), and 20% (for the 39.6% tax bracket). These rates are considerably lower than ordinary income tax rates. Contrast this with tax-deferred accounts that ultimately generate taxes on all distributions at ordinary income tax rates – including original contributions, interest, dividends, and appreciation.
  • No minimum distribution requirements – Employer retirement plans and IRAs require account owners to take regular distributions starting at age 70-1/2, even if the money is not needed. The same is true, regardless of age, of inherited IRAs/Roth IRAs. Such distributions may elevate the taxpayer’s marginal tax rate and may also cause more Social Security benefits to be taxed. Distributions from an after-tax account are much more “kind” in terms of impacting the income tax bill, both Federal and State.
  • Estate planning flexibility – Assets in after-tax accounts can be transferred to heirs at a stepped-up tax cost basis or may be gifted during lifetime in a way that suits the owner(s). Options for employer retirement plans and IRAs/Roth IRAs are much more limited. Lifetime transfers, for example, are not allowed. And while retirement/IRA/Roth IRA assets smoothly transfer on death by beneficiary designation, such transfers to non-spouse beneficiaries require that these beneficiaries take required annual distributions over their lifetimes with an associated tax consequence – all at ordinary income tax rates.

Does all of this imply that after-tax accounts are good and retirement/IRA/Roth IRA accounts are not? No, not at all. Each has its pros and cons. A well-designed financial plan can map out the correct mix of each, depending on an individual’s goals, access to various plans, income level, time to retirement, and other factors. A trusted financial planner should be consulted to help determine what is right for you.

This material is provided for general information purposes only. Investments and insurance products are not FDIC insured, not bank deposits, not obligations of, or guaranteed by Canandaigua National Bank & Trust or any of its affiliates. Investments are subject to investment risks, including possible loss of principal amount invested. Past performance is not indicative of future investment results. Before making any investment decision, please consult your legal, tax or financial advisor. Investments and services may be offered through affiliate companies.