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Retirement accounts don't get the benefit of lower capital gains tax rates

Retirement savings street signs

As Donald J. Trump has been making the campaign rounds in advance of the midterm elections, he's made some interesting — OK, wrong — comments about taxes.

And in trying to cover for explain those remarks, some folks are compounding the misinformation.

The latest example underscores a misconception about how retirement account withdrawals are taxes.

Trump's tax cut talk: Trump has been touting a pre-Nov. 6 tax cut of 10 percent for the middle class.

While nothing is impossible in this crazy world, that's not likely since Congress is not scheduled to return to Capitol Hill until Nov. 12.

Many Trump supporters, however, have been coming up with what they assume he means. And, yes, it's time to insert that old what happens when you assume joke here.

The latest example comes from David McIntosh, president of the Club for Growth, a Washington, D.C., group that wants to keep cutting taxes.

But in trying to lend cover to Trump's latest tax cut promise, McIntosh seems to have confused the tax treatment of retirement accounts.

Capital gains tax cut redux: McIntosh, who served the Indiana House district just before now Vice President Mike Pence took the seat, said on MSNBC this afternoon that Trump might be referring to a possible executive order (EO) that would cut, via indexing, capital gains.

That idea has been floated before. It hasn't garnered a lot of support.

In addition to posing potentially complex administrative issues, opponents argue that indexing capital gains would benefit primarily wealthy taxpayers. And those are the folks, they say, who already got the bulk of the tax breaks in the Tax Cuts and Jobs Act (TCJA).

McIntosh, however, said that if Trump did issue a capital gains EO, it would benefit the "middle class in a huge way because of all the retirement accounts."

That immediately made me, as C+C Music Factory sang, go hmmm (or huh?).

Ordinary not capital gains taxes: It seems that McIntosh is among the many who don't realize that just because a retirement account is invested in an equities, the account is not going to get the same favorable tax treatment as a basic, non-retirement investment.

The three capital gains tax rates are 0 percent for lower income investors; 15 percent for most middle-class folks in the markets; and 20 percent for top earners. They apply to the profit made on the sale of assets held for more than a year.

Ordinary taxes, those that we pay on our wage and salary income, are across seven tax rates and income brackets under the TCJA. And these rates, not capital gains rates, apply to tax-deferred retirement account distributions. 

If you're in the 22 percent, 24 percent, 32 percent or 35 percent ordinary income tax brackets, you'll pay those rates on your traditional tax-deferred retirement earnings instead of the lower 15 percent capital gains.

The highest earners will face a 37 percent ordinary tax on their traditional tax-deferred retirement distributions, not the 20 percent top capital gains tax.

So McIntosh's claim that a capital gains tax cut will help middle income individuals, implying it will lower taxes on their retirement accounts is wrong.

I'm not trying to pick on McIntosh. He might not be a tax guy. He might have just misspoke or been given the wrong information. And in any of those instances, he's not alone.

Over the years covering taxes, I've seen a lot of people surprised and upset by the way tax-deferred retirement savings are treated. They think, as noted earlier, that since they put their post-work money into an investment vehicle, it would be taxed at capital gains rates.

Sorry. But life and taxes aren't always fair.

That's why it's crucial to make informed decisions about where you put your retirement money.

Traditional retirement plan and tax options: There are investment and tax arguments for both tax-deferred and tax-free Roth accounts.

Let's start with a traditional workplace 401(k) retirement plan, which can give you upfront tax savings. The money you contribute goes into the account on before your paycheck taxes are figured, meaning the amount of federal and state income tax withheld likely will be at least a bit lower.

Yes, despite some early tax reform discussions of turning workplace 401(k)s into Roth accounts on which you pay tax on the money before you contribute it, traditional pre-tax 401(k)s survived the TCJA.

Your invested 401(k) cash then earns over the years on a tax-deferred basis. That means you don't owe tax on it until you withdraw it when you're 59½ or older.

The system is similar for traditional IRAs.

Depending on your income and whether you (or your spouse if you're married) have a retirement plan at work, you might be able to claim your IRA contribution as an above-the-line deduction. Yes, this tax break also survived the TCJA.

This means your traditional IRA helps you save for retirement, again on a tax-deferred basis, and gives you, if eligible, a current tax break.

But when you take that money out of such tax-deferred retirement accounts, you owe tax on it at ordinary tax rates.

Roth tax advantages: That tax treatment is a big reason that many tax and financial advisers suggest going Roth.

With a Roth 401(k), which some companies now offer in addition to a traditional workplace plan, your account contribution is made with money that's already taxed. The same is true with a Roth IRA.

That means you get no possible paycheck tax break like with a traditional 401(k) and no deduction from a Roth IRA.

But since you already paid tax on the money before putting it into the Roth, it grows tax-free over the years and, best of all, you don't owe any tax on the earnings when you withdraw from the account after at least five years or later when you retire.

Making wise retirement plan choices: Of course, making any tax or retirement move requires you to take a good look at many things and make some predictions:

  • What's your current income and tax situation? Do you qualify for or need an immediate retirement account tax deduction?
  • Where do you expect to be in the future income and tax wise?
  • What do you think tax law might be when you retire?
  • What you want to get out of your money, now and down the road.

So choosing a traditional or Roth retirement account is not a simple decision.

But it's one we all need to take the time to assess and make and in light of all the correct information. Not on the basis of incorrect and/or politically motivated statements.

And McIntosh's statement about a capital gains tax cut helping middle class folks with regard to their retirement accounts was just wrong.

Traditional 401(k)s et al are taxed at ordinary tax rates. And Roth retirement accounts are not taxed at all, not at ordinary income tax and not at capital gains tax rates, upon withdrawal.

And But it's one we all need to take the time to assess and make and in light of all the correct information. Not on the basis of politically motivated statements.

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