Tax Planning is step 7 of 7 in your do it yourself financial plan. The use of tax deferrals, tax deductions, and tax credits is good tax planning that legally reduces your tax liability . The one that most of you are familiar with is tax deferral . That is because most of you have a 401K plan or some sort of deferred compensation plan (403b, 457, etc) at work.
For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan to build wealth, you’ll pay income taxes on $90,000 instead of $100,000 so you saved taxes on $10,000 of income. Woohoo!!!
Most of you also get a “matching contribution” from your employers. For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is half of every dollar up to 6 percent of your salary. Each year, you contribute 6 percent of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer. That’s an automatic, no risk return of 50% on your investment! Woohoo! Among employees younger than 59 ½, 54% did not take full advantage of the company match according to a recent study .
Now the downside – okay, so you can’t take the money out until you are 59 ½ years old or there are severe penalties – like a 10% federal penalty and 2.5% state penalty (if you live in CA) plus federal and state income taxes on the amount withdrawn. A cash withdrawal on a credit card is cheaper than this . But that is why they call it a retirement plan, folks. It really is for when you retire.
Let’s talk about the deferral part . If you could save $15,000 a year for 30 years in your 401K and let’s assume you only got a 5% return annually on your investment, you would have accumulated $67,016. But if you had it in a taxable account (assuming a 25% federal and 6.8% state tax rate), you would have accumulated only $41,662. Big difference! Taxes do eat into your return.
The Pension Protection Act of 2006 was signed into law on August 17 by President Bush . The PPA contains many changes for defined contribution plans (401K, IRA, Roth IRA, SEP-IRA, etc). To make sure that you are taking advantage of these changes, and put the maximum contribution to your 401K plan to work now, see your Financial Advisor .Tax planning is an essential step to build wealth . -Fern Alix LaRocca CFP® Wealth Coach