One of the best ways to save on federal taxes is to do something you should be considering anyway: Put money away for retirement.
Financial advisers maintain that people who don’t contribute to a tax-deferred retirement plan, socking away funds for their golden years, are missing a bet. “If you can live without the cash, you should take full advantage of tax-deferred savings plans,” said Philip J. Holthouse, a Los Angeles-based tax accountant. It doesn’t make sense not to.
Here’s why: Many people get up-front deductions for voluntary retirement plan contributions. That means that if you put $1,000 in one of these accounts, your actual expenditure is probably in the range of $720--assuming a 28% tax bracket. Uncle Sam kicks in the other $280.
In addition, investment earnings accrue tax-free until you pull the money out at retirement. That allows you to earn interest on Uncle Sam’s dime. And given the ambivalence many Americans feel about the federal government at this time of year, that’s often both profitable and satisfying.
There are three types of tax-favored retirement accounts available to most Americans: Individual Retirement Accounts, 401(k) plans and Keogh accounts. However, each type of account has limitations on who can contribute and how much they can contribute while maintaining the tax benefits.
* IRAs allow taxpayers not covered by another qualified pension plan to deduct contributions of up to $2,000 per year, and defer paying taxes on their investment earnings as well. They can, moreover, take those up-front deductions regardless of their income level.
Those covered under other retirement plans, however, will lose some of the tax breaks if their income exceeds certain levels. The up-front deductions begin to phase out for single taxpayers who earn more than $25,000 and married couples with more than $40,000 in income. The deductions phase out completely when these income levels exceed $35,000 and $50,000 respectively. However, everyone can shelter their IRA investment earnings from tax until they pull the money out at retirement.
IRA contributions can be made until April 15 of 1992 and still qualify for a deduction on your 1991 tax return.
* Keogh plans are designed for individuals who are self-employed or have some self-employment income. These plans are a bit more difficult to set up and are subject to a variety of rules and limitations. Nevertheless, if you have significant earnings and don’t expect to need some substantial amount of your income until you retire, a Keogh plan is probably a better option than an IRA: You can deduct only $2,000 in contributions to an IRA, but up to about $30,000--or 25% of your self-employment income--in annual contributions to a Keogh plan.
To get a 1991 deduction for Keogh contributions, you must have the Keogh plan set up before year-end. Your banker or financial adviser can probably help you with the paper work and calculations.
* Perhaps the most attractive of all retirement plan options is the 401(k). These plans are only offered through employers, but by now, most of the nation’s biggest companies offer them.
These plans allow you to contribute up to $8,475 of your pretax income, and often allow you to help choose how your money is invested. Better yet, some employers offer “matching” contributions up to certain levels. If an employer matched up to 25% of the employees’ contributions up to $2,000, for example, an employee who put in $1,000 would have saved $1,250.
With or without matching contributions, investing in a tax-deferred retirement plan makes financial sense. Comparing these accounts to taxable investments is a bit tricky, but it underscores how gratifying these investments can be.
Consider two identical individuals in the 28% tax bracket. One wants to put $1,000 in a taxable savings account, the other in a tax-deductible, tax-deferred vehicle such as an IRA, 401(k) or Keogh.
The individual who put money in a regular savings account must actually earn $1,389 to save the $1,000, because he had to pay $389 in federal tax first. Assuming he put the $1,000 in the bank and earned an 8% annual return, he would have saved $1,660 after 10 years.
The investor who puts money in a retirement plan can save the entire $1,389 because he has no federal tax liability on this money. At the end of 10 years, earning the same 8% interest rate, he has $2,997. Of course, when these funds are pulled out of savings, the retirement plan investor must pay tax on the full amount, which at the 28% rate amounts to about $839. (The other investor paid tax as he went along.)
In the end, the retirement plan investor has $2,158, or $498 more than the other investor. Put another way, he has earned 30% more on the same after-tax investment.
All you give up is full access to your funds. If you pull retirement dollars out of savings before you are 59 1/2, you usually must pay a 10% tax penalty.