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Thousands
of investors sunk billions of dollars into these equities, seeking
tax breaks. However, they sacrificed their rate of return for tax savings.
Now, there are fewer tax shelters that exist, and fewer people
using them to their advantage! Hopefully, after reading this, you
won’t be one of them.
IRAs
These accounts are most commonly used to accumulate wealth for
many reasons. First, they allow you to grow your money at a taxdeferred
rate. Second, you don’t have to begin taking money out of
the account until you reach 701/2 years of age. Third, you can deposit
up to $3000 per year before tax. (You deduct the amount you contribute
from your taxes.) Although $3000 doesn’t sound like a great
deal of money, over time it does accumulate. Plus, the more money
you contribute each year, the faster it will grow.
Roth IRAs
The main difference between IRAs and Roth IRAs is that the Roth
contribution isn’t tax-deductible. However, it’s a great way to shelter
your money and let it grow tax-deferred. The Roth is also subject to
the same maximum contribution limits as the traditional IRA, but
when you begin to take the money out, it will be distributed tax free.
So, while contributing to a Roth won’t save you money on your tax
bill currently, it could save you, potentially, a large amount of money
during your retirement.
401(k), 403(b), and 457 Accounts
Most people are familiar with these types of retirement accounts that
are offered by employers, typically large companies, and tax-exempt
organizations, such as most nonprofit organizations, hospitals, and
schools. The beauty to these accounts is that they help lower your
current taxable income. When you invest in a 401(k), 403(b), or 457,
the money comes out of your paycheck before the tax is taken out.
Then when the tax is calculated, it is done so on the remaining
amount of the paycheck. Therefore, if your paycheck is for $1000 per
week, and you divert $100 each pay period to your retirement
account, you are only taxed on the remaining $900, thus lowering
your taxable income and tax due.
This year, the federal government has increased the amount of
money you can invest in a 401(k), 403(b), and 457 to $11,000 per
year. This number will continue to increase until the year 2006, when
it reaches $15,000 per year. Therefore, you could potentially reduce
your taxable income by up to $11,000 this year!
SEPs
SEPs, or simplified employee pension plans, are retirement
plans that use IRAs or IRA Annuities as the receptacle for contributions.
SEPs are often attractive to small business owners
because of the reduced administrative tasks and expenses. Documentation,
reporting, and disclosure requirements are simpler for
SEPs than for qualified plans. However, in exchange for simplicity
is the loss of flexibility. For example, under an SEP, all employees
must be covered as long as they meet specified requirements,
and the benefits must be fully vested at all times. SEPs allow
employers to make contributions to an employee’s retirement without
utilizing a more complicated retirement plan, like a 401(k).
You can use SEPs if you are incorporated or if you have selfemployment
income, so check with your CPA to see if you qualify
to establish a SEP.
From a design perspective, the SEP is quite similar to the
profit-sharing plan. The plan may also allow employees to make
pretax salary deferrals, like in a 401(k) plan. The maximum
employer contribution to the SEP is 25 percent of the compensation
of all employees eligible to participate in the plan. If an
employer sponsors several profit-sharing plans and SEPs, all plans
are aggregated under this rule. The maximum amount that can be
allocated to each participant from employer and employee contributions
is the lesser of 100% compensation or $40,000 (indexed
for 2002). The cap for the compensation that applies to SEP is
200,000 (indexed for 2002).
Annual income = $75,000
25% of $75,000 = $18,750
SEP contribution = $18,750
Annual income = $325,000
25% of $325,000 = $81,250
SEP contribution = $40,000 (Maximum Limit)
Keogh plans
The term Keogh Plan refers to an employer-sponsored plan that
covers a self-employed individual such as a partner in a partnership,
an individual member of limited liability company, or a sole proprietor.
The plans are named after a congressman that first introduced
legislation allowing self-employed individuals to sponsor these types
of plans. For many years these plans were subject to more stringent
rules and limits on contributions than plans sponsored by corporations.
Today, all types of business choose from among the same group
of quilified plans. A sole proprietor, instead of establishing a Keogh
Plan, establishes a profit-sharing plan, defined-benefit plan, or other
plan from the array of tax-advantaged retirement plans. The only distinction
that still exists is the manner in which self-employed individuals
detrmine their income for purpose of applying the limitations.
The self-employed indviduals’ contributions or benefit is based on
net earnings instead of salary. Note that net earnings can be determined
only after taking into account all qualified business deductions,
including the deduction for the retirement contribution.
Therefore, the amount of net earnings and the amount of deduction
are dependent on each other.
Profit-Sharing Plans
The maximum employer contribution to the profit-sharing plan is
the same as for an SEP, that is 25 percent of the compensation of all
eligible employees. For these plans, though, you need to establish a
vesting schedule, which will allow you to phase your employees into
the plan over time.
For example, you participate in your company’s profit-sharing
plan. After two years there, you decide that it would be best if you
were to find another job. Because of your company’s vesting
schedule, you may only be able to take a portion of your profitsharing
plan with you; typically after two years it would be 40 percent.
You are always able to take 100 percent of your contribution.
The 40 percent only refers to the employer’s contribution. Generally,
after five years of participation, an employee is 100-percent
vested and would be able to take all of the proceeds from the plan
and roll it over into another plan. Vesting schedules often work
as a deterrent for employees who may be prone to frequent job
switching.
Money-Purchase Plans
These plans are also part of the Keogh plans and can be set up separately.
The difference between the profit-sharing and money-purchase
plans is that employers need to establish a set percentage of
the payroll that will be deposited into this account. These plans are
rigid and don’t allow for any flexibility. While your employer may
be able to deposit up to 25 percent of payroll, whatever he chooses
he needs to stick with. Therefore, if he decides that he will contribute
20 percent of payroll, then he will continue contributing 20
percent. The maximum annual contribution that an employee can
receive is the lesser of 100 percent of salary or $40,000.
Annuities
Annuities are a great tax shelter because there is no limit to the amount
of money you can invest in an annuity during a given year. However,
there is no tax write-off for this investment. The money simply grows
on a tax-deferred basis until you annuitize the account. Plus, within
variable annuities you can switch between the different annuity subaccounts
at no cost and without triggering any type of taxes.
I regularly recommend annuities to clients who would benefit
from tax-deferred growth of their money. I once read an investment
book where the author cautioned against investing in annuities
because of the surrender. However, I disagree with those who believe that annuities
are a poor investment choice. There are many good reasons for
investing in annuities and I’m not against recommending annuities if
I believe that they are good for the client.
Life Insurance Policies
There may come a time when either a financial advisor or an insurance
agent tries to sell you on the idea of using a life insurance policy
as a means to accumulate the cash value on a tax-deferred basis
that can then be used for retirement. This isn’t a good idea because
the policy is insurance and it’s an expensive idea. When you pay the
premium on the policy, a part of it pays the cost of insurance. The rest
then goes into a separate account where it grows tax-deferred. Therefore,
just because you are paying in $200 per month doesn’t mean
that the whole amount is going to be invested. Your cost of insurance
could be $100 out of that $200, leaving just $100 per month being
invested. It’s far better to direct that $200 into a different account
where the whole amount can grow.
There are many financial advisors and insurance agents who
would like you to believe that life insurance is an investment vehicle.
Yes, life insurance does allow your money to grow tax-deferred.
However, these are insurance policies first and foremost. If you are
considering purchasing a life insurance policy make sure that you
need the insurance. Do not purchase one because you have been told
that they are great investment tools. Life insurance policies are good
for estate planning, and I have recommended them for that purpose,
but never for an investment choice.
These investment choices, however, aren’t totally fail-safe.
Rather, they are only as good as the underlying equities are. While
you should definitely remember to try and save as much on your tax
bill as possible, don’t sacrifice investment results and rates of return
only because you are saving on your tax bill. If you decide that
another security offers a better track record and potential return, but
is currently taxable to you, it may be a better idea to invest in that
security rather than the tax-deferred accounts.
Another important factor to tax shelters is that the government
tries to not let you take advantage of them if your income is substantial.
Contributions to Roth IRAs are phased out at certain income
levels, as well as the tax-deductibility of traditional IRA contributions.
Before you jump in and decide that one of these investments is
a good idea for you, you need to know if it will be beneficial to you
in the long run. Plus, you need to see if you will even benefit from
the tax deduction, or if your adjusted gross income is above the
required maximum. |
Disclaimer
