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Most of us could always stand to put a few more bucks into our retirement accounts. After a decade of lackluster returns for stocks during the 2000s, you may well have a lot of catching up to do in saving for retirement, and even the raging bull market of the past three-and-a-half years hasn't brought major market averages back to their pre-financial crisis levels. Given that Social Security is under siege and company pensions are rapidly becoming a thing of the past, what you save for yourself is definitely the most reliable source of funds you can count on after you retire.
Yet there's an even bigger reason that now is the best time to start finding ways to funnel more money into tax-favored retirement accounts like 401(k) accounts and IRAs. With the looming fiscal cliff just months away, the incidental tax benefits that retirement accounts provide could get a whole lot more valuable.
The worst-case scenario
Without government action, a whole bunch of bad things are about to happen to your taxes. Let's take a look at the three basic categories of higher taxes that you may face:
1. Higher taxes on ordinary income are coming.
Without a tax law change, income tax brackets across the board are going to go up. Although most of the attention has focused on the impact on the rich of higher brackets, the changes could potentially affect anyone who pays tax.
At the beginning of 2013, current law provides for the lowest existing tax bracket of 10% to go away, reverting to 15%. That could add $870 to the tax bill of married couples with incomes roughly in the $20,000 to $70,000 range. And obviously, adding three percentage points to the current 25%, 28%, and 33% tax brackets would produce a big hit on higher-income taxpayers as well. Although both parties have talked about agreeing to the need to renew tax breaks on low- and middle-income taxpayers, it hasn't happened yet.
The more you put in a deductible IRA or 401(k), the less taxable income you'll have. With tax rates rising, the savings you'll get from contributing to a retirement account will also increase.
2. Higher taxes on investment income are coming.
The elimination of tax breaks on dividend income and the rise in long-term capital gains rates, while investment focused, will be costly for many taxpayers. Right now, those in the 10% and 15% brackets pay nothing in tax on qualified dividends, but that will rise to 15% in 2013 with no changes to current law. Those in higher brackets will lose the 15% limitation and pay whatever their higher rate is, up to 39.6%. That will eliminate the current penalty that investors in non-qualified dividend payers, including mortgage REITs Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) , have to pay -- but only by raising the rest of the playing field to match the higher rate.
For years, dividend stocks have attracted new capital. But the new rules will make it more important than ever to shelter dividend income inside a retirement account. In particular, on high-yielding stocks Frontier Communications (Nasdaq: FTR ) and Windstream (Nasdaq: WIN ) , which have yields of 8% to 10% and whose dividends are generally eligible for lower tax rates, you could end up paying more than two-and-a-half times as much in taxes as you do now in a regular account. In an IRA, by contrast, you'll save more of your hard-earned money and let it work harder for you during your career.
3. Excess taxes for high-income taxpayers are coming.
In addition to old tax law coming back to bite taxpayers, new increases are also on their way. Medicare withholding will rise by 0.9% once wages rise above certain limits -- $200,000 for most singles and $250,000 for joint-filing taxpayers. Also, a 3.8% surtax on investment income will apply to high-income taxpayers, making it that much more important to get high-yielding dividend stocks under cover of a tax-favored retirement account.
Get your money protected
To reduce your taxable income and therefore your tax bill, IRA and 401(k) contributions are one of the most effective things you can do. The sooner you get money into those accounts, the better off you'll be -- and even if the fiscal cliff somehow gets fixed, you'll still have done a lot to make your retirement that much more secure.
High-yielding stocks may belong in an IRA, but you should still make sure they're good stocks. Does Frontier Communications have what it takes to earn a spot in your retirement account? Decide for yourself after reading the Fool's premium report on Frontier, where you'll find valuable answers to your most pressing questions. Take a gander today.