Some taxpayers who have suffered dramatic stock losses in their 401(k)s and traditional IRAs are learning – for the very first time – that the losses within a qualified retirement account are useless for offsetting any capital gains they may have in non-qualified accounts. Borrowing the theme from the Las Vegas TV ad, “What happens within a qualified retirement account, stays within a qualified retirement account.”
Put another way, the fluctuations in value within a tax deferred 401(k) or IRA are meaningless for any tax purposes. The taxman does not care what you invest in, or how much it grows or declines, -until you start to withdraw from the account. Then he quickly looks at your (then) tax rate and holds out his hand for a payment of ordinary income tax on your withdrawals.
Note: One of the greatest taxpayer tools is being able to write off capital losses on income taxes, and it is not available for qualified retirement plans such as IRAs, and 401(k)s.
Notwithstanding the above, if you are serious about planning a comfortable retirement, you should always participate in your employer’s 401(k) program to the extent that you maximize your employer’s contribution. There is no better way to get ‘free’ money. The key is to consider what investments you place within those qualified accounts.
So how do you benefit from the capital gain and loss tax provisions?
You can set up an after-tax account with a broker or a mutual fund company. Vanguard and Fidelity are two good examples of large investment companies with low transaction and management fees.
If you think about it, since all 401(k) withdrawals (non-Roth) are taxed as ordinary income, they are a good place to buy investments that grow your money via interest rather than capital growth, because all interest payments are treated as ordinary income, whether from a pre-tax retirement savings account or after-tax account. A good example of what to keep in your 401(k) is your allocation of stable-value income funds, CDs, and bonds. They pay interest, which is taxed as ordinary income whether it is held inside or outside a qualified retirement plan.
On the other hand, equities are better handled in non-qualified accounts where you can get the advantages of long-term capital gains tax, and the opportunity to write off your losses.
As a good diversification practice, you may want to keep some stocks and equity funds in your 401(k), but select those that pay large dividends and have a relatively flat share value. Stocks and funds that are the most volatile and risky (and therefore have the greatest opportunity for growth) should be held outside the 401(k) – so you can take full advantage of gains and losses.
Some points to remember about non-qualified stock accounts. You pay taxes on the money before you invest, so your $100 earnings contribution will become a $75 (at a 25% marginal tax rate) after-tax investment. You will also pay annual taxes on your capital gains and dividends earned. In other words, you will lose the substantial advantages of a pre-tax 401(k). That – and the employer matching funds factor – is why we recommend that you contribute to your 401(k), first.
However, the advantage of adding an after-tax account (even a small one) is that if your stock holdings plummet, the taxman allows you to sell off your losing stocks and funds, and use the difference between what you paid for them, and the sale price to offset current and future gains on your income tax. A capital loss directly reduces your taxable income, which means you pay less tax. That’s always good.
Note: If you do sell losing stocks from an after-tax account, try to do so within the first 12 months of purchase, which will make the sale a short-term loss that offsets short-term gains, which are taxed as ordinary income.
Before selling your losers in a bear market, you should consider a stock “swap” and buy different stocks on the same day you sell your misfits. That way you will remain in the market at all times, -and not lose out if the market makes a fast break the day after you sell. Historically, the market has gained 30% in the first month after hitting bottom. You will miss a lot of growth if you are not in the market at that time.
You may “swap” any stocks or funds you choose, but be careful not to repurchase a “substantially identical” stock or fund to the one you just sold – for at least 31 days. By waiting that time-interval, you will avoid what the government calls “a wash sale” that would disallow your capital loss.
“Substantially identical” means the same stock or very similar stock funds. For example, it would not be a good idea to sell a Vanguard 500 Index Fund and immediately purchase a Fidelity 500 Index Fund. However, it would be perfectly acceptable to buy a Total Market Index Fund. It is also acceptable to sell Dow stock and immediately purchase DuPont, which is in the same asset class.
Note: If you sell appreciated equities from your non-qualified account, you will receive the huge benefit of the 15% (or less) capital gains tax on all stocks held for more than one year. If you sell the same stocks before you have had them for one year, you will pay ordinary income taxes on the gains, and that can mean a tax up to 35% – big difference. See the table below.
Tax bracket – Short-term rate – Long-term rate
10% —————- 10% —————- 5%
15% —————- 15% —————- 5%
25% —————- 25% ————— 15%
28% —————- 28% ————— 15%
33% —————- 33% ————— 15%
35% —————- 35% ————— 15%
One last reason for investing outside your company retirement plan is that every dollar you invest now, wherever you put it, means you will have a better opportunity to retire at a time you choose, and/or enjoy a better quality of life when you do retire. The old adage is indeed true – pay me now, or pay me later.
The earlier you start to invest in your retirement, the easier it will be to reach your goals. It’s never too late to start, but this is one game where catch-up is very difficult, and failure can be devastating.
Before you act, seek the counsel of your financial, and/or tax advisor. There are many ways to save for retirement, get to know all your options.
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