WASHINGTON (4/28/10)--In this tough economy, you may think tax shelters are of little use to you. But as President Barack Obama’s fiscal reform commission considers raising taxes in its war on debt, methods of reducing taxable income are more important than ever (The Hill
Apr. 13). This is especially true for retirement plans such as 401(k)s and individual retirement accounts (IRA). Here’s why:
* Tax shelters are off-limits for creditors. Unfortunately for many debtors, this will be important. Money in a tax shelter strengthens your hand if you have to negotiate with lenders and is protected if you end up in bankruptcy. * Federal deficits mean your taxes probably will be higher in the future. Tax shelters are more valuable as your tax rate goes up. By the way, this is also a reason to own a Roth IRA. By paying the tax upfront, assuming you’re 59 1/2 or older and the money’s been in the Roth at least five years, you don't owe taxes when you take money out. * Keeping bonds in a tax shelter increases returns. Recent stock market volatility has reminded investors to keep some money in bonds. But bonds, except for municipals, don’t get favorable tax treatment--unless they’re in a tax shelter. This is especially important if you hold Treasury inflation-protected securities (TIPS) bonds; always try to hold TIPS bonds in a tax shelter. Why? The value of TIPS bonds is adjusted twice a year for inflation and counts as taxable income. * You’ll be expected to contribute less if your children apply for financial aid for college. Money in tax shelters like an IRA or a 401(k) doesn't count against you in the federal formula for financial aid. Money in a regular investment account does. * The less money you have in retirement, the more your tax shelter will pay you. That’s because income tax rates are progressive--you’ll get to keep more of your money.
When you move investments into a tax shelter, your gains aren't taxed each year, but you make a trade. When you withdraw the money in retirement, except for a Roth IRA, the withdrawal is taxed as ordinary income. If that worries you, keep in mind that you are subject to the top 35% marginal tax rate only if you’re earning $370,000 a year in retirement, in which case you likely don’t have too much to worry about. If your situation is more like that of the average married couple in retirement, according to the U.S. Census you’ll live on about $31,000 a year. That would put you in the 15% income tax bracket. You’ll get to keep most of the money you withdraw from your tax shelters.