Tips for retirement plan investors

Q. I have been doing quite a bit of mutual fund trading in my 403(b) retirement plan via the Internet, trying to be aggressive with regard to the growth of my contributions. Recently a colleague said I'd be better off not doing this in my retirement plan, but in an ordinary taxable account. What do you think?

--ROGER B., via e-mail

Brad: Welcome to the wonderful world of electronic trading, Roger! There is much to be learned by the investors in today's stock markets. There are about three different types of accounts available to educators who want to dabble in the markets, and each type has its own special tax consequences. The smart frogs will weigh these consequences as they develop a sound retirement investment program.

Bob: The three main kinds of accounts that educator/investors have available to them are the regular trading account, the Roth IRA account and the 403(b) retirement account. Consider traditional IRAs (both deductible and non-deductible) as being the same type of account as the 403(b) retirement plan. We are grouping them into these categories in relation to the way the IRS will tax your gains, should your investment strategy pay off.

Brad: First let's discuss the regular trading account you could open with dollars that you have earned and on which you already have paid taxes. Any time you sell shares in a mutual fund held in a regular account, you will have either short-term or long-term capital gains (or losses). In the regular account, short-term gains (fund shares held fewer than 12 months) are taxed at the maximum rate that applies to all your ordinary income, which could be as high as 39.5 percent. However, if you hold the shares longer than 12 months, any gains become long-term capital gains, which means the highest tax the gains could receive is 20 percent, and it could be much less than that, depending on your other ordinary income. In short, in this type of account you are punished for trading frequently and given a bit of a break for taking a "long-term" perspective. But also note that you didn't have as much money to invest because you had to pay taxes first.

Bob: Next, let's look at performing the same kinds of trades with salary that was not taxed but placed in a 403(b) retirement plan. Now you have more money to play with because no taxes were taken out by federal or state agencies. In this account, it doesn't matter whether your trades produce short- or long-term capital gains because when you finally begin making withdrawals from this account, every withdrawal will be treated as ordinary income. Roger, that means you'll pay ordinary income taxes of up to 39.5 percent. So the comparative advantage of using your 403(b) versus an ordinary account is that the ordinary account requires you to pay taxes first and the 403(b) does not. However, that advantage is offset by the higher taxes you'll pay on the long-term gains in the 403(b) as compared to the regular account.

Brad: Your third option is to do your trading inside a Roth IRA. We like Roth IRAs for aggressive investors. As with the regular account, you pay taxes up front on the money you place in the Roth IRA (a maximum of $2,000 per year). Like the 403(b), there is no distinction between the tax treatment of short-term and long-term gains. However, if you reach age 59 Z\x, and it has been at least five years since you opened your account, you can make withdrawals and pay no income taxes whatsoever on the earnings you've accumulated in the account. That's right, Roger, tax-free income! This is why we think educators who are aggressive investors are better off trading inside a Roth IRA. There is no punishment for short-term trading. So think about a Roth IRA for your day trading.

Bob: And remember Roger, we are only talking about what happens if your account goes up in value because of gains. It's a different story if you have capital losses. Losses in your retirement plans are not tax deductible as they would be in your regular account when you realized them, of course.

American Federation of Teachers, AFL•CIO - 555 New Jersey Avenue, NW - Washington, DC 20001