Making the Most of Tax-Deferred Savings Plans
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These gems will also speed you along the road to wealth. Not only can you get an immediate federal income tax deduction or its equivalent for your contribution, but over the years the effects of tax-deferred compounding can be awesome. For instance, if a 35-year-old earning $60,000 a year annually routinely contributes 6% of his salary to a taxable account earning 8% a year, he would have $185,744 by age 65, assuming a 30% tax rate. Not bad. If he were to invest that money in a tax-deferred account, however, he would amass a hefty $407,820 –more than twice as much. And even if he then withdrew the entire amount and paid taxes at a 30% rate on the proceeds, he would still be ahead by 64%. You can read about these retirement plans in greater detail in “How to Retire Comfortably”, but here are the most important things you should know:
Employee savings plans. Mentioned earlier in this topic, these programs siphon off a percentage of your salary into your employer’s retirement savings plan. These are simply the best savings deals available today. Because you save the money before it’s taxed, the size of your contribution if effectively a deduction from your federal (and often state) income taxes.
Individual Retirement Accounts. If you have no tax-deferred saving plan at your workplace, you ought to do some disciplined tax-deferred savings on your own. Don’t overlook the humble IRA. Even though Congress has limited the deductibility of IRA deposits (raising the bar a bit in 1997), you can still write off some or all of your contribution if you’re not covered by a retirement plan at work or if you’re married and have an adjusted gross income of less than $60,000 ($40,000 for singles). And the 1997 tax law created a new type of IRA, known as the Roth, whose withdrawals are fully tax-free if you’ve had the IRA for at least five years and you’re 59 ½ or older at the time. The Roth IRA is not deductible, however. If you don’t qualify fir an IRA deduction and your income is too high to open a Roth, you can still contribute up to $2,000 annually in a nondeductible IRA and watch those earnings grow tax-deferred.
Since tax rates on upper-income people were raised in 1993, nondeductible IRAs have become much better deals for people in tax bracket of 31% or higher. But before you make a nondeductible IRA contribution, first contribute the maximum allowed to an employer-provided plan such as your 401(k), if you have one. Then aim to set aside the maximum $2,000 or $2,250 in an IRA account each year.
Retirement plans for the self-employed. If you own a small business or are self-employed, you can use a Simplified Employee Pension (SEP) that lets you write off as much as 13.0435% of your annual income, up to $30,000, and defer taxes on the earnings. (If you’re an employee and your firm offers a SEP, you can fund it with up to 15% of your income). SEPs are pretty simple to set up and require little record keeping.
A business owner can also get up a so-called Keogh plan, which allows you to contribute anywhere from 15% of annual gross income to $118,000. Keoghs can be kept at almost any institution that offers qualified plans such as IRAs. With a defined-contribution Keogh, you can contribute –and deduct from your taxable income –either as much as $30,000 a year or 20% of your net self-employment income, whichever is smaller. With a defined-benefit Keogh, you decide how much income you want to receive each year in retirement, within federal limits, and then contribute the right amount each year to achieve that benefits. Say you are 55 and haven’t saved a lick. You can begin saving and deducting whatever it takes (up to $90,000 a year if you earn that much) to give yourself a retirement income equal to the average of your earnings in your three consecutive highest paid years. Every year you must submit to the IRS a form on which an enrolled actuary has made the official calculation for your defined-benefit Keogh plan.
Deferred compensation plans. Another form of forced savings, these plans are designed for highly paid executives who can afford to put aside a portion of their earnings. You make an election to defer a bonus or part of your salary until a stated time and you are not taxed on the income until you actually receive it. By deferring part of your compensation, you hope to avoid a current tax of, say, 36% or 39.6%, and ultimately pay tax at a lower rate on funds that have appreciated tax-free in the meantime. To set up a deferred compensation plan, you must enter a written arrangement with your employer.
The problem with a deferred compensation plan is that there’s no guarantee the employer will actually deliver on its promise. One type of arrangement that provides more security for an employee is a so-called rabbi trust, so named because this arrangement was approved by the IRS for a synagogue and its rabbi. Your employer sets up an irrevocable trust in your name and stashes part of your salary in it every year. Of course, postponing your pay still involves some risk. For instance, you have no control over your trust, which could be seized by creditors to pay your employer’s debts should the firm go bankrupt.
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