With qualified plans, all investment income, such as capital gains, dividends. and taxable interest, is deferred until the owner takes distributions from the plan. At that time, the money is taxed at ordinary income rates, regardless of how long the asset has been held by the owner. Any dividends, taxable interest, or capital gains that would normally be currently taxable under directly owned invest- ments isn’t. The distributions from these plans may be stretched out over many years, thus delaying the payment of taxes and allowing the tax-deferred feature of the investments to continue.
Any changes that are made within the tax-advantaged plan are done so tax free. This means that any selling or exchanging of invest- ments can be done without triggering any capital gains taxes, as long as it is done within the qualified plan. The advantage here is that any asset that has appreciated in value may be sold or exchanged tax free, so as to fully realize the gain. However, any assets that would be sold for a loss are better to be sold outside of the tax-advantaged plan (as a directly owned asset) in order to use the capital loss for tax pur- poses.
Unfortunately, there are some limitations to holding assets in these tax-advantaged plans. For starters, there is no step-up in basis at death for these plans. Second, although the gains in the assets may have been through capital gains, the capital gains tax rates don’t apply when the money comes out. Plus, participants must follow the guidelines of their particular plan when it is an employer-sponsored plan. The employer is also allowed to make changes to the plan for the future.
There are also tax implications for these types of plans. While deferring the gains on these plans is an advantage, pulling the money out and paying taxes on it at ordinary income rates may be viewed as a limitation. (The exceptions to this are Roth IRAs and education IRAs, where the money comes out tax free.) For many people, when they begin to draw from their tax-advantaged plans, they may be pay- ing more in taxes than if they were pulling money out of their directly owned assets. For example, you take a distribution of $20,000 from your traditional IRA. You will pay taxes on this amount at ordinary income levels. However, if you were to pull out $20,000 from your directly owned asset, and it was viewed as a gain, then you would be