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When it comes to saving for retirement, the best tools at your disposal are tax-favored savings vehicles like IRAs. Yet as valuable as IRAs are for retirement planning right now, they're going to get even more important to smart planning next year.
The primary benefit that IRAs and other tax-favored retirement accounts have is that they let your money grow without having to pay tax as you go. Yet with certain quirks of the tax code, investing in an IRA actually came with a cost for many investors. Now that new taxes are rearing their ugly head, though, it's a lot clearer just how much an IRA can save you over a regular taxable account.
The IRA dilemma
At first glance, you might figure that investing in an IRA always makes more sense than using a taxable account. After all, you're bound to get some taxable income from your investments over the course of your career, and if they're in a traditional IRA, you don't have to worry about actually paying tax on that income until you withdraw the money after you retire.
But the one thing you don't get in an IRA that you do get from a regular taxable account is the benefit of lower tax rates on capital gains and dividends. In particular, long-term capital gains and dividend income on stocks you hold in a taxable account qualify for the current maximum tax rate of 15%. But if you earn that income inside an IRA, the distributions you make during retirement don't get that tax-rate reduction. As a result, you can end up paying as much as 35% on the same income in an IRA.
The best examples of this come from high-growth, no-dividend stocks. One key industry has for growth over the past five years has been from the Internet services arena, where priceline.com (Nasdaq: PCLN ) , Netflix (Nasdaq: NFLX ) , and Amazon.com (Nasdaq: AMZN ) have all profited greatly from their respective niches in providing vital, high-demand online services to huge groups of consumers. Even with a big correction from Netflix, all three of these stocks have at least tripled in the past five years. Yet if that appreciation came in an IRA, the gain from each original $1,000 investment will bring $700 in eventual taxes on IRA distributions, versus a $300 capital gains tax for the same price appreciation in a taxable account.
However, some of the same issues affect dividend-paying stocks as well. For instance, tobacco stocks Altria (NYSE: MO ) and Philip Morris (NYSE: PM ) have been dependable dividend payers for years, thanks to ongoing cash flow from their cigarettes. But even when you have to pay tax on dividends along the way by owning shares in a taxable account, your much lower rate makes the tax hit from their relatively high yields a lot easier to handle.
Making it easy
New tax law changes taking effect in 2013 make it clearer that IRAs are the better choice. Under current law, rates on dividend income in taxable accounts will shoot up to the same rate as ordinary income. By removing the discounted tax rate on dividends, you'll have a lot more incentive to get all your dividend stocks into IRAs.
Capital gains rates aren't slated to go up as much, with maximums hitting 20% next year. That will still leave true long-term buy-and-hold investors in a better position using taxable accounts. But if you're like most investors and trade in and out of positions at least occasionally throughout your lifetime, the friction from having to pay those taxes along the way could make an IRA a better bet.
Moreover, the new Medicare surtax will hit directly at investment income. With an additional 3.8% tax applying to investment income on single filers with adjusted gross income above $200,000 and joint filers above $250,000, you'll save even more from having your income-producing investments in an IRA.
Don't miss out
It's not a certainty that the full extent of these higher taxes will pan out. It's always possible that Congress could take steps to extend some low rates well into the future. But with at least some tax increases coming, you can't afford not to take a closer look at how an IRA could help you save.
Once you've got an IRA, the next step is finding smart investments. We've got some good ideas for you in the Fool's special report on stocks that will help you retire rich. Get your free copy today while it lasts!