Tax Strategies

Tax Deferred Income

How Can I Generate Tax-Deferred Income?

Tax deferral is an extremely attractive component of any tax planning strategy.

The income you earn on your principal is allowed to compound tax deferred until you withdraw the money. Only at the time of withdrawal do you become liable for taxes.

Tax deferral is encouraged by the government to stimulate long-term planning, especially retirement planning. Individual retirement accounts, Keogh plans, 401(k)s, and other qualified retirement plans all benefit from tax deferral.

In addition, many insurance-related vehicles, such as annuities (both fixed and variable) and certain life insurance contracts, include the benefit of tax deferral.

There is a substantial benefit to deferring taxes as long as possible. The compounding effect can be dramatic over an extended period of time and can make a substantial difference in the accumulation of a retirement nest egg.

In fact, the difference can be even more dramatic when choosing whether to invest IRA funds (or any other type of funds) in tax-deferred vehicles at the beginning or the end of the year. Using a hypothetical 8 percent return (compounded annually), if the maximum annual contribution (under the 2001 tax law) was invested in an IRA at the start of each year, after 30 years it would have accumulated $533,482. On the other hand, if the contribution was made at the end of each year, the IRA would have accumulated $493,965, a difference of $39,517.*

One note of caution: When formulating your tax plan, recognize that most tax-deferred investments do incur penalties for withdrawal prior to age 591/2. The government not only taxes you at that point, but also imposes a 10 percent penalty. Once again, the government is encouraging long-term planning.

Another nice feature of the tax-deferred investment is the flexibility to choose from the complete spectrum of investment vehicles. Under the tax-deferred umbrella, you can select an equity portfolio, a fixed income portfolio, or a combination.

Tax-deferred income investments, which reduce your current tax liability and can increase your net worth, may be an attractive addition to your portfolio.

* Assumes $5,000 annual contributions for 2008 and thereafter

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Mutual Fund Profits

How Can I Keep More of My Mutual Fund Profits?

Provisions in the tax law allow you to pay lower capital gains taxes on the sale of assets held more than one year. The maximum long-term capital gains tax rate is 20 percent (10 percent for individuals in the 10 or 15 percent tax bracket). Short-term gains — those resulting from the sale of assets held less than one year — are still taxed at your marginal income tax rate.

In addition, for investments acquired starting January 1, 2001, and held for a minimum of five years, capital gains are taxed at a lower rate of 18 percent. For those in the 10 or 15 percent tax bracket, any investment held for a minimum of five years and sold after January 1, 2001, will qualify for lower capital gains taxation at a rate of 8 percent.

This means that if you’ve been buying shares in a stock or mutual fund over the years and are considering selling part of your holdings, your tax liability could be significantly impacted by the timing of your sale.

The main pitfall for most investors is the IRS’s “first-in, first-out” policy. Simply stated, this means the IRS assumes that the first shares you sell are the first shares you purchased. Thus, the first shares in become the first shares out. As a result, if the value of your shares has appreciated, more of the money you receive from the sale will be considered taxable as a capital gain.

Fortunately, there is an alternative. When you place a sell order, instruct your broker or mutual fund transfer agent to sell those shares that you purchased for the highest amount of money. This will reduce the percentage of the proceeds of the sale that can be considered capital gain and is therefore taxable.

In order for this strategy to work, you must specify exactly which shares you are selling and when they were originally purchased. Ask your broker to send you a transaction confirmation that identifies by purchase date the shares you want to trade. This will enable you to minimize your taxable gain and maximize your deductible losses when you fill out your tax return.

In some cases, you may be better off selling the first shares you purchased even if this results in a larger gain. If the first shares are subject to the 20 percent long-term capital gains rate, but the recently purchased shares are subject to a higher, short-term rate, the correct choice may not be obvious. Always consult with a tax professional.

Some transfer agents for no-load mutual funds will not go through the trouble of isolating by purchase date the shares you want to sell. That doesn’t necessarily mean you are stuck with the first-in, first-out computation.

By carefully reviewing your brokerage statements, you can determine which shares you paid the most for. You can then specify exactly which shares you’d like to sell. A word to the wise: Make this request in writing. If the IRS calls the transaction into question, the burden of proof is on you.

Finally, the IRS also allows you to calculate your tax basis by taking the average cost of all your shares. On an appreciating asset, this will result in a lower tax liability than the first-in, first-out rule would dictate.

Be aware, though, that if you elect to average, you must continue to average for any subsequent sales. You don’t have to stick with share identification for future transactions. Either way, you may end up with a lower tax liability from the sale of your shares than the IRS would assume using the first-in, first-out rule.

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Future of Social Security

Will Social Security Retire Before I Do?

People have traditionally seen Social Security benefits as the foundation of their retirement planning programs. The Social Security contributions deducted from your paycheck have, in effect, served as a government-enforced retirement savings plan.

However, the Social Security system is under increasing strain. Better health care and longer life spans have resulted in an increasing number of people drawing Social Security benefits. And as the baby boom generation (those born between 1946 and 1964) approaches retirement, even greater demands will be placed on the system.

In 1945, there were 41.9 active workers to support each person receiving Social Security benefits. In 2000, there were only 3.4 workers supporting each Social Security pensioner. And it is projected that by 2030, there will be only 2.1 active workers to support each Social Security pensioner.1

You should consider that as your income gets higher, Social Security replaces a proportionally smaller percentage of retirement benefits. It used to be that you could receive full benefits only after you reached age 65. But in 2003, the age to qualify for full benefits will begin to increase on a graduated scale. By 2027, the age to qualify for full Social Security benefits will have increased to age 67, where it is scheduled to remain.

That means in the future, you will probably have to wait longer to qualify for full Social Security benefits to start replacing a smaller percentage of your pre-retirement income.

Your long-term retirement planning program should recognize Social Security benefits as playing a more limited role when calculating required retirement income. Indeed, some financial professionals suggest ignoring Social Security altogether when developing a retirement income plan.

Source: 1 Social Security Administration

Note: The Social Security Administration will now assist you in calculating your projected retirement benefits. You can call 1-800-772-1213 and ask for Form SSA-7004, the “Personal Earnings and Benefit Estimate Statement,” or you can access the form on the Internet at www.ssa.gov. Complete the form, return it to the Social Security Administration, and you will receive an estimate of your benefits.

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Social Security Income

How Much Social Security Income Can I Expect?

Estimating your future Social Security benefits used to be a difficult task, but not any longer. The Social Security Administration now provides an estimate of all future Social Security benefits to any taxpayer who requests it.

Simply submit a copy of Form SSA-7004. You can obtain a copy by calling 800-772-1213, or apply over the Internet at www.ssa.gov.

This form asks you for a number of facts about yourself, including your name, Social Security number, date of birth, previous year’s earnings, the age at which you plan to retire, and how much you expect to earn between now and retirement.

Based on this information and its own records of your previous Social Security payments, the Social Security Administration will produce an 8-page report called a Personal Earnings and Benefit Estimate Statement. This document, which will arrive in four to six weeks, lists all the benefits you’re likely to receive upon your retirement.

Monthly Benefit

Your report will contain an estimate of your monthly retirement check from Social Security, in today’s dollars, based on when you’re planning to retire.

It will also contain an estimate of the amount you would receive if you were to wait until full retirement age, (assuming you’re planning on retiring earlier), and an estimate of the larger benefit you would receive if you were to continue working until you are 70 years old.

Survivor’s and Disability Benefits

Based on your age, your family can receive special survivor’s benefits in the event of your death. Your children will receive a percentage of your retirement benefit until they reach age 18, and your spouse will receive your full benefit when he or she turns 65. This report estimates the value of these benefits as well.

If you are unable to work for at least a year or if you are terminally ill, you’ll be eligible to receive disability benefits. Your report will also include an estimate of the size of these benefits. Like survivor’s benefits, disability benefits include income for dependent children.

Statement of Earnings

Finally, your report will contain a year-by-year statement of your earnings that were subject to Social Security withholding. You should carefully check these numbers against your own records; occasionally the Social Security Administration will make mistakes. It’s best to resolve any discrepancies long before you need the retirement benefits.

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KEOGH Plans

What About Retirement If I’m Self-Employed?

Keogh plans were created to provide a tax-sheltered retirement option for self-employed taxpayers. They can provide some very attractive tax benefits.

Unlike individual retirement accounts, which limit tax-deductible contributions to $3,000 per year, Keoghs allow you to save as much as $40,000 of your net self-employment income, depending on the type of Keogh plan you adopt. And you are allowed to have a Keogh plan in addition to another retirement plan such as an IRA.

The money in a Keogh plan grows tax deferred until you withdraw it. When you withdraw these funds, you can take advantage of some of the tax-saving techniques — such as 10-year forward averaging — that aren’t available to IRA depositors.

You can open a Keogh account through banks, brokerage houses, insurance companies, mutual fund companies, and credit unions. Although the federal government sets no minimum opening balances, most institutions set their own, usually between $250 and $1,000.

Fees and commissions vary, so it makes sense to shop around.

Deposit Deadline

The deadline on a Keogh plan is sooner than it is for an IRA. You must open a Keogh by December 31 of the year for which you wish to claim a deduction.

You don’t have to come up with your entire contribution by then, though. Much like an IRA, you don’t have to deposit your contribution until the day you file your tax return. That gives most taxpayers until April 15 to deposit their annual retirement savings into a Keogh account.

Necessary Paperwork

Unfortunately, the paperwork that is required to open a Keogh account is cumbersome. You’ll be required to fill out forms that ask very specific questions about your business, your Keogh plan’s vesting schedule, and the appointment of an administrator of the plan. You may want to use the services of an accountant in filling out these initial forms.

Unless certain exceptions are met, Keogh owners must also file disclosure Form 5500 or 5500-EZ annually.

Some banks and brokerage houses offer their customers written advice on filling out these forms.

If you’re self-employed on either a full- or part-time basis, a Keogh plan could be a valuable addition to your retirement strategy. And the potential payoff — a comfortable retirement — may far outweigh the extra paperwork.

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Managing Retirement Accounts

How Should I Manage My Retirement Plan?

Employer-sponsored retirement plans are more valuable than ever. The money in them grows tax deferred until it is withdrawn at retirement. Distributions from a tax-deferred retirement plan, such as a 401(k) plan, are taxed as ordinary income and may be subject to an additional 10-percent federal tax penalty if withdrawn prior to age 59 ½. And contributions to a 401(k) plan actually reduce your taxable income.

But figuring out how to manage the assets in your retirement plan can be confusing, particularly in times of financial uncertainty.

Conventional wisdom says if you have several years until retirement, you should put the majority of your holdings in stocks. Stocks have historically outperformed other investments over the long term. That has made stocks attractive for staying ahead of inflation. Of course, past performance does not guarantee future results.

The stock market has been extremely volatile lately. Is it a safe place for your retirement money? Or should you shift more into a money market fund offering a stable but lower return?

And will the instability in the markets affect the investments that the sponsoring insurance company uses to fund its guaranteed interest contract?

If you’re participating in an employer-sponsored retirement plan, you probably have the option of shifting the money in your plan from one fund to another. You can reallocate your retirement savings to reflect the changes you see in the marketplace. Here are a few guidelines to help you make this important decision.

Diversify

Diversification is a basic principle of investing. Spreading your holdings among several different investments (stocks, bonds, etc.) may lessen your potential loss in any one investment.

Do the same for the assets in your retirement plan.

Keep in mind, however, that diversification does not guarantee against loss; it is a method used to manage risk.

Find Out About the Guaranteed Interest Contract

A guaranteed interest contract offers a set rate of return for a specific period of time, and it is typically backed by an insurance company. Generally, these contracts are very safe, but they still depend on the security of the company that issues them.

If you’re worried, take a look at that company’s rating. The four main insurance company rating agencies are A.M. Best, Moody’s, Standard & Poor’s, and Duff & Phelps. A.M. Best ratings are based on financial conditions and operating performance; Moody’s, Standard & Poor’s, and Duff & Phelps ratings are based on claims-paying ability. You should be able to find copies of these guides at your local library.

Periodically Review Your Plan’s Performance

You are likely to have the chance to shift assets from one fund to another. Use these opportunities to review your plan’s performance. The markets change. You may want to adjust your investments based on your particular situation.

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Saving Now vs Later

What Are the Advantages of Saving Sooner? Most people have good intentions about saving for retirement. But few know when to start or how much is enough. Far too many people use credit cards as an additional income source and sink further into debt. This leaves precious few dollars to put aside for savings and retirement. And the interest on credit cards builds up much faster than interest on a savings account.

Of all workers, about one-third have saved less than $10,000 for retirement.1 A better approach might be to allocate a certain amount for savings every month and pay yourself as though it were an expense.

Let’s look at two friends, Chris and Leslie, who are both 45 and saving for retirement 20 years from now. Their financial advisor has told them that they need some savings in addition to their employer-sponsored retirement plans. Both save $275 a month for a 10-year period, and both earn 8 percent on their investments. But there is a difference.

Chris starts saving today and saves for 10 years. But Leslie waits 10 years before starting to save. Both will have put away a total of $33,000. After 20 years, Leslie, the procrastinator, will have accumulated $49,534, whereas Chris, the early starter, will have accumulated $106,941. That’s more than twice as much available for retirement with the same initial investment.
(This is a hypothetical example used for illustrative purposes only and does not represent the performance of any specific investment. Rates of return will vary over time, particularly for long-term investments. Taxes and inflation were not considered. Actual results will vary.)

This example makes a strong case. Not only does it pay to save, but if you start sooner, you can take advantage of the power of compounding. For example, your deposits earn interest and so does your reinvested interest. This is a good example of letting your money work for you. The sooner you start saving for retirement, the more you will have when you retire. And the sooner you start saving for retirement, the sooner you will be able to retire.

If you have trouble saving money on a regular basis, you may try savings strategies that force you to save. Examples of forced savings strategies are whole life insurance, employer-sponsored retirement plans, and direct payroll deductions. These financial vehicles allow you to take your savings directly out of your paycheck as an expense. This means you’ll be paying yourself even before your creditors. Some of these options, such as whole life insurance and employer-sponsored retirement plans, may also have deferred tax advantages that further increase the advantage of saving early.

Distributions from a tax-deferred retirement plan, such as a 401(k) plan, are taxed as ordinary income and may be subject to an additional 10 percent federal tax penalty if withdrawn prior to age 591/2.

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Source:
1. 2001 Retirement Confidence Survey, Employee Benefit Research Institute