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It's awfully hard to win a game if you don't know the
rules.
Yet, every year millions of Americans play the income tax
game without fully understanding the rules. Once a year, they try to skim through the
rulebook - the tax return instructions - and try to join in the fray without developing a
playbook.
When you think about it, St. Louis Rams football coach Dick
Vermiel couldn't have led his team to a Super Bowl victory with such a slapdash strategy.
So, we'd like to offer you some suggestions on how to use
tax-deferred savings accounts to help you set aside some money for retirement while
reducing your tax bite.
The 1999 Tax Year Strategy
With only one month to go until T-day, unfortunately your
options for your 1999 return are somewhat limited. For the 1999 tax year, we can only
offer one real piece of advice. If you haven't contributed to an IRA yet, do it. The
deadline is April 17, 2000.
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| For more on making a 1999 IRA contribution in
2000, click here |
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You should be aware that if you participated in an
employer-sponsored 401(k) plan in 1999 you may not be able to deduct your entire
contribution to an IRA from your taxes. You won't be able to deduct the full $2,000
maximum-allowed contribution if you were a single filer and earned more than $41,000. If
you are married, filing jointly and earned more than $61,000 you won't be able to deduct
an IRA contribution either.
If you didn't participate in a work-sponsored plan, your
entire traditional IRA contribution is tax deductible.
Get A Head Start On 2000
This may be of little help to those fretting over their
1999 return, but financial planners advise that this is an ideal time to start planning
for the 2000 tax year.
Here are some of their suggestions.
Build An Emergency Fund And Avoid Costly 401(k)
Withdrawals
First up, build an emergency fund containing enough money to cover three to six months of
expenses. Admittedly, having a fund like this won't help reduce your tax liability in the
short term. When it helps is if you have a crisis down the road, said Phillip Cook, a
Torrance, California-based certified financial planner.
Many people like 401(k) plans because of the hardship
withdrawal feature. They figure that if they need money they'll take from the plan.
However, that's expensive money.
"The reason to have the emergency cash reserves is
because the penalty to take the money out (of a tax-deferred savings account) plus the
income taxes makes the withdrawal expensive," he explained.
With an emergency fund in place, you won't even have to
think about tapping your 401(k) plan.
Saving: Tax-deferred Accounts vs. Out of Pocket
Let's face it, most of us are pretty good at making resolutions to save. It's our
discipline that usually falls short, because it seems we can always rationalize spending
money when it's in our pocket. But, when you combine automatic deposits and tax-deferred
savings, your balance can grow very quickly.
Carmen Petote, a certified financial planner in Pittsburgh,
offers a good example. He was making a work-site presentation trying to get employees to
sign up for the company 401(k) plan. At the end of what he thought was a somewhat futile
effort, a woman got up to speak. "'I've got $3,000 in my plan and I don't have $3,000
saved anywhere else,' she said," Petote recalled.
Seizing upon this example, Petote quickly ran a future
value calculation showing how $3,000 would grow in several decades. That's all it took for
the audience to buy in. "I got a lot of people signed up after that meeting," he
said.
"The important point was that the woman became
accustomed to the automatic payroll deduction and never missed the money," he said.
By using tax-deferred tools, you can save more before taxes but the after-tax impact feels
the same.
Here's how it works.
Suppose you take $100 out of your wallet and put it into a
savings account. Over 30 years, assuming a 10% return and a zero tax rate on the profits,
that money will grow to $1,744.94.
Unfortunately, the world isn't that simple. If that money
came out of your paycheck you paid taxes on it before it reached you. If you're in the 28%
tax bracket, you had to earn $139 in order to have $100 in your pocket. The IRS took the
extra $39 for federal taxes.
Therefore, if $139 was deducted from your paycheck and put
directly into a tax-deferred, employer-sponsored retirement program, like a 401(k), in
your pocket you would only feel $100 poorer, points out Dennis Filangeri, a Metarie,
Louisiana.-based certified financial planner.
In the meantime, you have $139 working for you in the
401(k) account. And over 30 years, assuming a 10% return, that money will grow to
$2,425.47.
"With a tax-favored investment, you can invest more
from your savings allowance," Filangeri said.
Even though you have to pay taxes on the money you withdraw
from a tax-deferred 401(k) or similar plan, you will still likely win out, as the
following table illustrates. (Remember, your tax bracket at retirement may even be lower
than it is now.) |
