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Imagine the government depositing thousands of dollars into your savings account each year and letting you keep the interest. Sound too good to be true? When you contribute to your 403(b) plan or 401(k) plan at work, that's exactly what happens.
Most employers offer either a 403(b) plan or a 401(k) plan as a way to help their staff save for retirement. Not-for-profit hospitals and universities generally offer 403(b) plans. Most other businesses offer 401(k) plans. Besides the name, there isn't a big difference between these two retirement savings plans these days.
Amounts contributed to either of these plans reduce your taxable earnings and grow tax deferred. For 2004, you can contribute up to $13,000 through salary deferrals. Anyone 50 or older by December 31 can sock away an additional $3,000. These amounts are in addition to any money that your employer contributes to the plan on your behalf.
Let's say that you're in the 28% federal tax bracket, and live in a state that has a 5% income tax. Your marginal tax rate, therefore, is 33%. By contributing $13,000 into your 403(b) plan or 401(k) plan at work this year, you'll save $4,290 in taxes ($13,000 * .33).
If you max out your contributions to this retirement savings opportunity, it only costs you $8,710 in after-tax dollars to have $13,000 in a portfolio of mutual funds growing tax-deferred. Do the math and you'll see that you already earned a whopping 49.25% return on your salary deferrals ($4,290/$8,710).
Yes, you'll need to pay back those taxes when you begin taking distributions out of your retirement account. But you get to keep the earnings on the tax savings for all the years that the money remains invested within your account.
How much will you end up earning on the government's money if you contribute $13,000 into your retirement account annually for the next 25 years and assuming an average rate of return of 8% per year on the money invested? Thanks to the power of compounding, the earnings on the $4,290 of tax savings that you get to keep invested within your 403(b) account or 401(k) account each year will exceed $230,000. I don't know of many other ways that you can legally pocket that much of the government's money without ending up with free room and board, and a complimentary wardrobe of orange jumpsuits.
Contributing to your employer's 403(b) plan or 401(k) plan is one of the best tax shelters available to professionals during their working years. And with the top federal tax bracket current running at 35%, and with the tax rates of some states approaching 10% or more, high income individuals will realize an even greater tax savings than the numbers reflected in this example. So even if money is tight, or a financial advisor is trying to steer you towards an alternative such as a Variable Universal Life Insurance Policy (VUL), maxing out this tax-advantaged retirement savings opportunity is generally too good of a deal to pass up.
It was the best of tax seasons for some people thanks to the recent tax-cut packages, and the worst of tax seasons for others due to the soon-to-be-ubiquitous Alternative Minimum Tax (AMT). How did you make out with your 2003 taxes?
Big Tax Savings
Many people saw a dramatic decrease in their federal tax liability due to a cut in the tax rates. While there was an across the board reduction of 2% on all but the lowest two brackets, the highest rate was cut from 38.6% to 35%.
The tax rates for investment income was slashed by even more for 2003. The rate for long-term capital gains was reduced from 20% to 15% for post May 6, 2003 transactions. And the tax rate on corporate dividends was cut from a maximum of 38.6% to just 15% as well. If you were fortunate enough to have any investment income fall within the lowest two brackets, you paid taxes on that income at a rate of only 5%.
I prepared a tax return that demonstrates how much money some people saved because of the new rules. This client's income has been running at approximately $90,000 per year, mostly from corporate dividends. For 2002, they paid just over $9,000 in income taxes, after factoring in all of their deductions. This year, their tax liability was only $1,641. That's a savings of more than 80%!
Hit By the AMT
For other people, the tax-cut package didn't live up to its full potential due to the AMT. This past winter, I prepared a tax return for a married couple who earn about $300,000 per year, with the bulk of their income coming from their salaries. While they did see their federal tax bill decrease, a large chunk of their tax savings was lost due to the AMT. This year, the AMT cost them $3,316 in extra taxes. In 2002, they didn't even pay $1.00 of AMT.
Why are so many people getting hit by this tax all of a sudden? A big reason is due to the fact that the regular tax rates are not much higher then the AMT rates these days. With the most recent tax-cut package, the highest two tax brackets of 33% and 35% don't exceed the top AMT rate of 28% by a heck of a lot any more.
The lower rates also pose a problem for taxpayers. The rates for the first three tax brackets are currently 10%, 15% and 25%, each of which is less then the lowest AMT rate of 26%.
To make up for the fact that their are no lower brackets for the AMT, you're allowed to claim an exemption when calculating the AMT of $40,250 if you're single or $58,000 if you're married. Here lies yet another pitfall. If you're single, you must start phasing out this exemption once your income exceeds $112,500. For married couples, the threshold is $150,000. If your income exceeds the applicable threshold, your chances of paying the AMT jumps.
Another reason you might end up getting hit by the AMT is because certain deductions aren't allowed when calculating the AMT including:
Every year, you're supposed to calculate your taxes two different ways. First, the regular way, and then, using the rules of the AMT. If the AMT exceeds your regular tax liability, that's the tax you pay.
Since certain provisions of the two recent tax-cut packages are scheduled to be around until 2008, and the remaining provisions scheduled to sunset in 2010, the AMT will continue to be a problem for lots of people. The word from Washington is that more then 30 million taxpayers could end up paying the AMT in 2010. Since avoiding the AMT won't be possible for many taxpayers, including the affect of this tax on your long term tax and financial planning is a must.
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