Tax planning is an activity that is best pursued year-round. You can use the following list of tax strategies to help you better carry out your planning on a regular and ongoing basis. As tax time approaches over the next few weeks, we will present a short list of the many things you can do to better plan your liabilities
Before-Tax IRA Earnings: Contributing before-tax earnings to an IRA account can make a big difference in your retirement savings, since you can defer paying taxes on whatever your investment earns in an IRA. If your investment pays dividends or has capital gains distributions (such as a some mutual funds), you avoid paying taxes on these gains. If you expect your tax rate to drop after your retirement, because you have less income, your savings could amount to an even bigger nest egg.
You may contribute up to $3,000 of your earnings or up to $3,500 if you are age 50 or more. If your modified AGI is above a certain amount, your contribution limit may be reduced.
The limit is scheduled to increases to $4,000 in 2005-2007, and $5,000 for 2008. The limit will be indexed (increased with the rate of inflation) in $500 increments starting in 2009.
If you earn an income from wages or your own business and you’re under the age of 70-1/2, you can open a traditional IRA. For lower income earners, the contribution itself may be deductible. Contribution can be made for the prior tax year up until April 15.
SEP IRAs: A “Simplified Employee Pension IRA” is a tax-deferred retirement plan provided by sole proprietors or small businesses, most of which don’t have any other retirement plan. Contributions are made by the employer, and unlike the traditional IRA, can be as high as 25% of each employee’s total compensation, with a maximum contribution of $40,000. For a sole proprietor, this can be a significant opportunity to save for retirement on a tax defer basis. Employees with SEP-IRAs can also invest in regular IRAs.
Aside from the higher contribution limits, SEP-IRAs are subject to the same rules as a regular IRA. Contributions and the investment earnings can grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income.
401 (k)s. A 401(k) plan is an employer sponsored plan that lets you contribute a percentage of your salary to a trust account, putting off any taxes on that money until you withdraw it, usually after age 59 1/2. Companies often match some of your contribution, and any taxes on those matching funds are also deferred, as long as the total going into the account does not exceed the limit for the year. Like with IRAs, the earnings in the account grow, tax free, until you withdraw the money, and if you expect your tax rate to drop after your retirement, because you have less income, your savings could amount to an even bigger nest egg.
Through automatic payroll deductions, you can usually contribute between 1% and 25% of your eligible pay on a pre-tax basis, up to the annual IRS dollar limit of $13,000 ($16,000 if you’re age 50 or older). In this case, you are making salary-reduction contributions that reduce your take home pay, but also your income tax basis, a significant tax break vs. “after tax” investments.
There are typically IRS penalties associated with early withdrawal of 401(k) assets, but many plans allow you to borrow against your assets. If you leave an employer, you may be able to keep your plan with the employer, or “roll it over” into an IRA, avoiding these penalties. Consult your plan administrator for details.
20% Withholding on Distributions from Qualified Employer Plans: Income tax withholding may apply to distributions made from qualified employer plans. Withholding at a rate of 20% is required on a distribution, unless it is transferred directly from your employer to an IRA trustee or another employer plan. The withholding rules do not apply to distributions from IRAs or Simplified Employee Pensions, also known as SEPs. However, if you wish to rollover a qualified plan distribution to an IRA, be sure to transfer the amount directly from your employer to an IRA trustee or another employer plan. Otherwise, 20% of the distribution will be withheld while 100% of the distribution must be rolled over within 60 days. If you don’t have the money to cover the 20% shortage, income taxes and possibly a 10% penalty will be due on the amount not rolled over.

Continued next week.

Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.

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