In a world of war and chaos, why it’s still the best tax shelter – Press Enterprise
Most analysts expect stock market volatility to continue amid concerns about inflation, rising interest rates, Russia’s invasion of Ukraine and the effect of possible variants of the virus.
However, even when markets fluctuate, there can be opportunity. This is the perfect time to review and perhaps modify your retirement plan. Here are some helpful strategies, as well as some techniques you may not know, to reduce your investment risk and maximize your tax savings.
First of all, there is no need to panic. Many of us who remember our 401k’s big losses in 2008 were shaken by recent market declines and may need a little comfort right now to keep us from selling. Here’s your insurance – If you invested $100,000 in the S&P 500 at the start of 2009, you would have approximately $684,000 at the start of 2022, a return on investment of 584%, or 15.83% per year.
Your best tax shelter
Also, it’s not a good idea to limit the amount you contribute to your retirement plan this year out of fear, especially if you need a tax deduction. What makes tax-deferred pension plans one of the best and last remaining tax shelters is that a contribution to your plan is deductible on your return and the taxes on retirement growth are deferred.
For example, if you contribute $20,000 to your 401k balance this year and are at a combined federal and state effective tax rate of 40%, your immediate tax savings would be $8,000 ($20,000 x 0.40), which is significant.
After the tax savings, your investment cost was only $12,000, not $20,000. Since you were able to invest more through the tax savings and the account will grow tax-deferred, your end-of-retirement balance will be much higher than if you had invested the funds in a non-retirement account with after-tax dollars.
If you’re hesitant to invest more of your hard-earned money in the financial markets, consider a self-directed IRA to invest in alternatives, such as real estate (including rentals and farmland), precious metals, and even startups. Alternative investments protect against stock market volatility, can generate higher returns and offer more flexibility. To open a self-directed IRA (SDIRA), you will need an SDIRA custodian who offers non-traditional assets.
Some employers also offer self-directed 401(k)s, and the custodian is the plan administrator. The same contribution limits apply to self-directed accounts as regular IRAs and 401(k) plans.
SDIRA companies cannot provide investment advice, which means investment research is your responsibility. Additionally, investing in alternative investments may involve higher risk, and some investments have income and net worth restrictions or require the investor to be a qualified (or accredited) investor.
Unfortunately, for traditional, self-directed pension plans, the maximum annual contribution will generally not be enough for most people to retire comfortably. If you’re 50 or older, the maximum you can contribute to your 401k annually is only $27,000 per year. The maximum annual contribution to the IRA or Roth IRA, if you are over 50, is only $7,000. Unlike defined benefit pension plans offered by large employers, 401ks and IRAs are defined contribution plans and do not provide a guaranteed fixed retirement income.
If you’re looking for greater financial security in retirement, here are two other alternative retirement options (of the many available).
Defined benefit plans
A defined benefit plan guarantees a specific benefit or payment at retirement, and it works more like a traditional pension plan. You can set up a defined benefit plan for yourself and your employees if you own a business. A defined benefit plan allows the business owner to contribute significantly more for retirement because the account must grow enough to provide the required annual payment when the owner retires.
Defined benefit plans are particularly powerful when the business owner is close to retirement age, and 20 years of savings can be built into 10.
The ideal investor in a defined benefit plan will be able to set aside $100,000 to $150,000 per year (although more is often allowed). They should have few (if any) younger employees, since the employer funds the plan and contributions are partially age-based. The employer (you) also gets a deduction for the contribution and you pay no income tax until you retire.
Defined benefit plans involve significant risks. Employers are required to make minimum contributions each year. The requirement does not depend on the performance of the company; even if you have a terrible year, you still have to contribute or face taxes and penalties.
Deferred charitable annuity
A charitable deferred annuity is simple to set up, but it offers a powerful way to save on your taxes and generate a fixed income for retirement while helping others. A DCGA involves an agreement between you (the donor) and a charity. The donor transfers money or other assets to the charity and receives a partial tax deduction and a fixed annual income stream at a time you specify in the future that is partially tax-free for life.
When the donor dies, the charity keeps what’s left. There is no limit to the amount you can contribute and you can carry forward any unused charitable deduction for five years.
Many use a DCGA when they still need a tax deduction after making the maximum allowable contribution to their traditional retirement plans. As an additional tax bonus, you can contribute other assets (not just cash) in exchange for the annuity and avoid capital gains on the sale of the assets. If you support a church, school or charity, contact their donor relations office for more information.
These are just a few alternatives to increase the likelihood that you can retire comfortably while comfortably reducing your current tax burden. Be sure to discuss all of your retirement options with your CFP and CPA, including Roth conversions.
As “Big” George Foreman, two-time world heavyweight champion, Olympic gold medalist and entrepreneur, said, “The question isn’t at what age I want to retire, it’s at what income. “
Michelle C. Herting, CPA, ABV, AEP, specializes in tax planning, trust administration and business valuations. It has three offices in Southern California.