How Do Government-regulated Retirement Plans Benefits Differ From Regular Savings Benefits?

Government-regulated retirement savings plans such as IRAs and 401(k)s are often called 'qualified plans' for short

. The have a specific taxation scheme that's not based on the investments you put into these 'plans'. The taxation of your regular savings or investments depends on the nature (or type) of the investment itself. In this article, I compare these two in terms their taxation benefits.

I'll distinguish between qualified plan savings and regular investment savings by calling the former 'QP-taxed savings' and the latter 'Investment-taxed saving'

By regular savings, here, refers to the money you've earned, been gifted, or inherited into and then invested by as in savings accounts, bonds, stocks, funds, or real estate. The taxation associated with these savings is dependent only on the type of investment and its earnings.

QP-taxed savings rules:

The defined-contribution qualified plans offered by your company like 401(k), 503(b) and your personal Individual Retirement Arrangement (IRA) are simply accounts that must follow a specific tax scheme. Their contributions can only come from your working income in the year of contribution. These contributions are annually limited - depending on the plan.

There are two types of plans:

* tax-deductible contribution plans and

* non tax-deductible plans (referred to as Roth plans).

Tax-deductible plans allow you to contribute work income and deduct that amount from your taxable income. Your earnings grow tax-deferred but everything you withdraw will be subject to income tax rates. Early (before 591/2) withdrawals are penalized too and you must make required distributions (MRDs) after turning 701/2.

Non-deductible (Roth) plans allow you to contribute similarly but without a tax deduction. So it's harder to contribute as much as you can to the deductible plans. But your earnings and future withdrawals are all tax free. Early withdrawals are penalized but there are no MRDs.

Some company qualified plans will match some of your own contributions to your employee qualified plan.

It doesn't matter what type of investment you choose to invest your 'qualified plan' money in. it's all treated the same and taxed as explained above. The 'advertised' benefit of these plans is really in the tax scheme.

These benefits are the deductible contributions, tax-deferred or tax-free growth, and tax free withdrawals depending on which of the two plan types you have. A disbenefit is the being taxed at ordinary income rates when you withdraw from your deductible plan. There's no tax benefit provision for any investment losses you suffer within the plans.

*Investment-taxed saving rules:

You can contribute as much as you want and from any source - like inheritance or gifts. These contributions have already been taxed and become the tax-basis of your investment -which will never be taxed.

The taxation scheme for your regular savings is based on the investment type you use. Income-generating investments like savings accounts and bonds have their interest earnings taxed annually as ordinary income - as are dividends, usually. Net real estate rental income is also taxed yearly as income.

Gains, beyond dividends and interest earned, in the value of your investment are taxed only when you sell and, then, at capital gain tax rates - a low rate for holding more than 1 year. You can generally deduct the loss for investments that sell for less than their basis.

*Key considerations when choosing to invest into 'QP savings' or 'investment savings':

Getting a return on your invested money - no matter where you invest it - is the name of the game. But the taxation scheme affects how much you get of that return.

Investment-taxed savings that grow by capital gains offers a very low tax rate; expenses for holding the investment reduce the capital gain; and you can deduct losses; and there's not tax on gains until you sell. Because of these attributes, put growth type investments into investment-taxed savings will give you more return than you'd get in a QP deductible saving plan.

QP-taxed deductible savings help you contribute more annually - but have RMD with withdrawals taxed at income rates. Non deductible QP-taxed investments are never tax and have no RMD. But both plans protect the annual taxation that cuts into investments with annual earnings. So use QP-taxed plans for those types of investments that kick out annual earning - like interest - that'd be taxed.

Also, since company QPs sometimes match some of your QP contributions, you should always contribute to them at least to get the matching money. You can't go wrong if you do.

by: Shane Flait

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