Sheltering Your Income from Taxes
Want to keep more of what you earn?
It’s that time of year again….the tax man is coming. It just so happens that one of the things that I enjoy most about my work is helping clients keep more of what they earn by sheltering their earned income.
Wages, salaries, tips, and other employee compensation, plus net earnings from self-employment all make up your earned income each year. In order to keep more of what you earn, you likely need to employ one or more tools to help. In fact, reviewing your taxable income status should be part of your yearly goal planning.
There are numerous ways to shelter your earned income from the tax man, and you don’t have to be an accredited investor to employ some of the most widely used methods; traditional deductible IRAs and employer-sponsored retirement plans. In some cases, you may also be able to shelter your earned income with deductions, losses and charitable planning. Of course there are also other special programs available to accredited investors.
While there are clearly many ways to go about sheltering earned income from taxation in financial planning, a basic approach that is often overlooked is simply deferring income. Very often, the earnings that you make on your retirement plan contributions are tax deferred. As a result, you are not required to include the amount of your contributions to these plans in your gross income, but instead would include these amounts in your income when distributed. No worries though, there are ways to plan for this eventuality as well.
Keep in mind that one of the main advantages of deferring taxation on current income through your retirement plan contributions is that when you eventually collect the benefits, it is possible that you'll be retired and/or in a lower tax bracket. In addition, prior to any distributions, your investment earnings will compound free of taxes within the plan.
Now, since reducing tax burdens gets me all excited, I want to focus a bit more on two of the simpler strategies that are often not taken advantage of…
Contributions to a traditional IRA can be tax deductible if you meet the requirements applicable to your individual situation. If your IRA contribution is tax deductible, then you may lower your adjusted gross income (AGI) by the amount of the contribution.
Quite simply, you are electing to defer the taxes on the AGI portion of your income until you withdraw that money from your IRA account. The earnings that accrue on your contributions also grow tax free until you take an IRA distribution and you effectively lower your tax bill now.
Employer-sponsored retirement plans can also provide you with an opportunity to defer your taxes. There are two kinds of retirement plans; qualified plans and nonqualified plans.
Qualified plans offer significant tax advantages to employers and their employees in return for strict adherence to ERISA requirements involving participation in the plan, vesting, funding, disclosure, and fiduciary matters. Nonqualified plans, on the other hand, generally do not impose such extensive ERISA requirements, but they are generally less beneficial from a tax standpoint.
There are many types of employer-sponsored qualified retirement plans that allow you to contribute your pretax dollars into the plan. These contributions are deducted from your paycheck and are not included in your income. You include amounts contributed to such qualified retirement plans in your income if and when you take a distribution from your retirement account in the future.
As with IRAs, your money (including the earnings) in a qualified retirement plan grows tax free until it is distributed. This is a significant advantage, especially if you do not intend to take distributions from the plan for several years.
Please contact me with any questions that you may have. As a CFP®, I can help you make sure that you have the right people on your team to coordinate all of your planning when it comes to reducing taxes or other important matters. It is key to make sure that you are tying all of this together so that you can make optimal use of your money each and every year.