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I contribute the max to my 401(k) and my wife and I both max out our IRAs. But the company my wife will start working for in January offers no retirement account of any type until she has been with the firm for three years.
Besides the IRA, is there any way my wife can invest some of her earnings in a tax-deductible savings account of some sort?
-- Michael, Albuquerque, New Mexico
Your situation highlights what I think is a weakness of the current employer-focused retirement savings system in the U.S. If you work for a company that has a decent 401(k) plan, you're set.
But if you work for a company that doesn't offer a 401(k) or similar system -- or, as in your wife's case, the employer's plan doesn't kick in for a few years -- then you're at a disadvantage.
True, you can always do an IRA, but the maximum contributions fall far short of those in 401(k) maximums.
And while the SEP-IRA option can be attractive, it's limited to the self-employed, which isn't much help to salaried workers like your wife.
The recent report issued by the president's tax reform panel contained proposals that would give people access to tax-advantaged (though not tax-deductible) retirement savings accounts beyond what their employers offer, with higher maximums than IRAs.
But who knows if these will ever see the light of day?
So where does that leave you and your wife?
Assuming you're both maxing out your IRAs, I don't see any way for your wife to contribute to another retirement savings account that will give her a tax deduction. But that doesn't mean she can't save in a tax-advantaged way.
One excellent option is a tax-managed mutual fund. Your wife won't get a tax deduction, but the managers of this breed of funds use a variety of techniques -- such as offsetting gains and losses -- to minimize taxable distributions to shareholders.
So in many cases you can avoid recognizing any gain until you sell. And if you hold the fund more than a year before selling, you're taxed at the long-term capital gains rate, which maxes out at 15 percent.
You can achieve the same effect by buying and holding stocks, as long as you're adept at choosing individual shares.
In effect, by investing in a tax-managed fund, your wife gets to shelter her gains as long as she holds the fund shares. And once she sells them, she'll be taxed at a rate no higher than 15 percent, assuming Congress doesn't re-write the tax laws in the meantime.
For more on how tax-managed funds work -- and why index funds can also be a good way to lower your investment tax bill -- click here.
The annuity trap
There is also a lesser option, which is a tax-deferred variable annuity. The money she invests doesn't qualify for a tax-deduction, but all the investment gains go untaxed until you withdraw the money from the annuity, preferably many years from now.
Since sheltering gains from taxes sounds pretty good, why am I not giving this option an unqualified thumbs up?
Two reasons. First, variable annuities tend to carry onerous fees in the form of bloated annual insurance charges and in early surrender penalties that whack you if withdraw your money within a few years of investing.
The second problem is that while your returns do escape taxes in the annuity, once you withdraw your gains they're taxed at ordinary income rates even if they're actually long-term capital gains.
Capital gains that would be taxed at no more than 15 percent in the case of a mutual fund may be taxed at rates as high as 35 percent when they're withdrawn from an annuity.
Generally, you've got to be willing to hold a variable annuity 15 or more years to overcome the lofty fees and the fact that your gains will be taxed as ordinary income.
So until your wife qualifies for her employer's 401(k) plan or until Congress revises our retirement savings system, I recommend that you and your wife look into tax-managed funds. They won't give you the tax deduction you want. But by keeping Uncle Sam's hands off your gains until you sell, these funds can effectively boost your returns and help you build a larger retirement nest egg over the long run.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."
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