There Are Still Good Ways to Defer Taxes
Tax time again, you’ve finished the returns, and you’re frustrated because there are so few deductions left. The 1986 Tax Reform Act took away practically everything but home mortgage interest and charitable contributions, and it limited eligibility for saving pretax income in an individual retirement account (IRA).
So what’s an honest citizen who’d like to save for retirement or other purposes to do? Look around. There are more ways to save tax-deductible and tax-deferred dollars than you might think.
To begin with there’s the IRA. The 1986 Act cut back--but didn’t eliminate--the opportunity to deduct $2,000, put it in an IRA and earn income tax-deferred until age 59 1/2. Still eligible are employees--like many in small business--not covered by company pension plans. Couples with incomes below $50,000 a year or invididuals making less than $35,000 are eligible for partial or fully deductible IRAs.
And everybody is eligible to earn tax-deferred income on after-tax IRA contributions--although fewer are doing so. Contributions to IRAs fell from $38 billion in 1986 to $15 billion the following year and continue to decline, says Washington’s Employee Benefit Research Institute. A lot of people are ignoring the wonders of compound, tax-deferred interest. To illustrate, $1,000 at 7% interest doubles in about 10 years, becomes $3,000 at 17 years, $5,000 at 24 years and $8,000 in 30 years.
Meanwhile, most people are unaware of a whole other side to the IRA. Called the simplified employee pension, or SEP-IRA, it is for self-employed individuals, partnerships and small business owners. But the self-employed category also includes moonlighting wage earners who can shelter up to $30,000 a year earned outside their principal job. That is, income from free-lance consulting, speech-making, carpentry, auto repair, writing, you name it, can be put into a SEP-IRA even if the individual works full time for a company that provides a pension. “Free-lance work is your best deal going,” says a government tax expert.
One of the best. There are also 401(k) plans, which allow employees to put aside pretax income, accompanied usually by a contribution from employers. Such plans contain a double benefit because the company’s money becomes the employee’s as the plan starts vesting, usually within five years.
Suits Conditions
Since they were authorized in 1981, big companies have favored 401(k) plans as a benefit spanning high- and low-wage employees. But now smaller firms are setting them up, explains Lorrayne Chu, a vice president of Fidelity Investments, as companies such as Fidelity and Merrill Lynch take administrative burdens off employers’ hands in return for the right to market mutual funds and other investments to employees.
In all, it adds up to a big and growing bundle of tax deductible savings--$106 billion in 401(k)s, and almost $400 billion in IRA and Keogh accounts--as some pension plans for self-employed professionals are called.
The buildup is occurring because it suits today’s conditions. An employee’s interest in 401(k) and IRA accounts can be carried from job to job, as traditional pensions cannot. Such portability is necessary when individuals average only three years on each job.
It also suits changing patterns in business. More than 20 million people work as independent contractors these days, as companies favor such arrangements to avoid paying medical and other benefits.
But most of all tax-deductible savings answer the need of a population that is living longer for a future supplement to the Social Security check. Meanwhile, young people needing to pay for housing or kids’ education can borrow against retirement plan savings.
The effect of such plans may be surprising. “These savings plans will create wealthy employees,” says Philip Roberts, head of investments for Aetna Life & Casualty. “I don’t mean the Big Charlies, but the average people. Employees in these plans for 30 years will be able to walk away at 55 or 58 with $1 million.” That’s roughly $225,000 in present value (discounting 30 years at today’s inflation rate). So it won’t be a pot of gold, but it could be a nice nest egg. And a that’s a consoling prospect at tax time.
