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! Yet a recent study found that, among employees younger than 59 ½, 54% did not take full advantage of the company match!.
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like a 10% federal penalty and 2.5% state penalty (if you live in CA) plus federal and state income taxes on the amount withdrawn.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.
Now let’s discuss 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 yearly 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.
President Bush signed the Pension Protection Act of 2006 into law on August 17 . 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 . To build wealth tax planning is an essential step . -Fern Alix LaRocca CFP® Wealth Coach
