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Tax favored investments, or "qualified plans," are currently functioning in an environment characterized by the following factors:
1. An increasing number of different plans have become available, e.g., Roth IRAs, SIMPLES, and self-employment plans (including Section 401(k) plans).
2. The contribution limits are becoming more generous, e.g., self-employment Section 401(k) plans allow both employer and employee contribution for a sole proprietor, there are catch-up provisions for participants over age 50, IRA plans may receive $3,500 a year instead of $2,000, etc.
3. Most Americans are now in the maximum 15 percent tax bracket, since the 15 percent bracket on a joint return extends to $58,100 (in 2004), plus exemptions and deductions!
4. Participants, and sometimes their advisers, do not always understand both the tax and the economic aspects of qualified plans. Thus, many taxpayers do not realize that Roth IRAs and traditional IRAs are mathematically identical, while others believe that buying life insurance in a qualified plan, in and of itself, is a good deal, even though the cash value build-up would be tax free in any event and anything bought by a plan is tax deductible, etc.
Perhaps the most fundamental question to ask before making a long term investment is: Are qualified plans always suitable as vehicles for long term investments, and under what circumstances, if any, may informal, taxable plans be more appropriate?
CHARACTERISTICS OF QUALIFIED PLANS
All qualified plans have three basic characteristics:
1. The investment is 100 percent deductible up front;
2. Current income is not taxed; and
3. All assets in the plan, be it principal, tax exempt income, or capital gain, lose their character since all distributions are taxed as ordinary income.
Investments with no current income, e.g., art, collectibles, real estate, and growth stock, are quite common, as are investments with lightly taxed income, e.g., qualified dividends taxed at 15 percent or less. Thus, the importance of avoiding tax on current income varies by investment! The transformation of all plan assets, however accumulated, to distributions of ordinary income is often viewed as a disadvantage, except to the extent the plan participant is in the 15 percent tax bracket.
WITHOUT SIGNIFICANT INCOME OR APPRECIATION THIS LEAVES ONLY ONE POSSIBLE ADVANTAGE OF A QUALIFIED PLAN, WHICH IS THE IMMEDIATE EXPENSING OF THE FULL INVESTMENT IN THE HIGHEST POSSIBLE TAX BRACKET!
In order to compare investments inside and outside of a plan, we often need to use the time value of money as illustrated below.
THE IMPACT OF SPECIAL CIRCUMSTANCES
The Worthlessness Scenario: The Qualified Plan Is Better!
Sometimes it is instructive to look at extreme scenarios. For example, if a qualified plan investment becomes worthless, the participant still received an ordinary deduction up front, i.e., the investment is already written off! Outside the plan the investment cannot be expensed until worthlessness occurs, perhaps years later, and then most likely as a capital loss.
The No-Income Scenario
To isolate the …