Home Ownership, Individual IRAs Also Provide Tax Shelters
New Laws Boon for Contributing to Retirement Plans
BY ROBERT GOLDSTEIN
Looking for a good tax shelter? One solid piece of advice is to take advantage of a 401(k) plan, which offers many people the best tax shelter available, although other options are available.
While individual retirement accounts and home ownership present alternative tax shelters, recent legislation affecting 401(k) and other tax-qualified retirement plans dramatically increased the contribution limits for most Americans and establishes them as the shelter of choice for many.
Recent studies reveal that there has been a steady decline in the amount of retirement savings in this country despite the fact that the tax "subsidy" for retirement plan contributions has consistently been the second largest federal subsidy, behind the deduction for medical expenses.
Increasingly concerned about this trend, last year Congress enacted new laws providing the largest retirement plan contribution increases in almost three decades. Effective for contributions made this year, the 2001 tax legislation, known as the Economic Growth & Tax Relief Reconciliation Act of 2001, provides an immediate boost to all employees participating in employer-sponsored 401(k) and other retirement plans.
Following is a summary of new benefits offered under the act, options presented through home ownership and new information on individual IRAs.
- Enhancements For Common Law Workers
If you are a so-called "common law employee," receiving an IRS Form W-2 each year participating in your employer's 401(k) plan, you may already be enjoying the higher contribution limits. Although the $11,000 401(k) contribution limit this year is only $500 more than last year's, the growth act increased this amount by $1,000 a year for each of the next four years starting in 2003. After the annual limits reach $15,000, they are then adjusted for changes in the cost of living.
For many years, the amount an employee could contribute each year to his or her 401(k) plan was based solely on changes in the cost of living. Translation: low inflation equals small increases. Since 1993, the most the contribution limit could be increased in a single year, regardless of inflation, was $500. In fact, in some years the contribution amount was never raised. That was true, for example, in 2000 and in 2001 when the contribution limit was $10,500 for both years. This was not a great problem when the stock market was consistently throwing off double-digit returns.
But, given the performance of the stock market the past two and a half years and with money market and cash funds generally earning less than 5 percent now, the amount of a person's pre-tax contribution amount is of paramount importance. Thus, the $1,000 annual increases, unprecedented since 1978 when 401(k) plans became part of the American landscape, should add significantly to the retirement savings of Americans.
The act made other enhancements to the retirement plan rules. Until this year, the most an employee could contribute was 25 percent of his or her compensation. So, if compensation last year was less than $42,000, he or she couldn't even reach last year's $10,500 contribution maximum ($42,000 x 25 percent = $10,500).
The act increased this limitation from 25 percent of compensation to 100 percent. This makes it easier for even employees at lower compensation levels to make the maximum 401(k) contribution.
And that's not all. If one is 50 or older this year, Congress provides an additional carrot. Under the act, one may contribute an extra $1,000 to a 401(k) plan this year without regard to the amount of compensation. The extra amount increases by $1,000 a year starting in 2003 so that by 2006, the extra contribution amount reaches $5,000 a year. By today's standards, it's impressive to think that by 2006 those 50 and older will be able to contribute $20,000 to their employer's 401(k) plan ($15,000 + $5,000).
The overall contribution limits resulting from both employer and employee contributions were also increased this year from $35,000 to $40,000. This is an overall limit that can come from any combination of 401(k) contributions, employer matching contributions or employer profit sharing contributions. And again, the limit is actually $41,000, if you are 50 or older this year.
- Self-Employed Taxpayers
Typically, employees have little or no control over the amount their employers set aside into their retirement plan. For many individuals, their elective contributions are the only amounts that reach their 401(k) accounts. However, the self-employed are, in a sense, both the employer and the employee and thus, are able to decide for themselves what benefits they will fund into their retirement plan. The act also increased the potential retirement savings for the self-employed.
Self-employed taxpayers may be either sole proprietors (their income is reported on a Form 1040, Schedule C) or partners in partnerships (their income is reported on a Form K-1).
One of the principal advantages of owning your own business is that it is possible to establish a retirement plan, even if one already participates in an employer's plan. Depending on income level, it is possible to have $40,000 funded into each of the retirement plans.
In addition, as a result of the act, the restrictions on funding these amounts are far less restrictive this year for the 17.6 million self-employed people eligible to establish and fund their own plans. Thus, they can now deduct up to 25 percent of their income rather than the 15 percent permitted under prior law.
For some, the shelter provided by home ownership is an attractive and viable option. In San Diego this is especially the case as, historically, California has enjoyed one of the most vibrant housing markets in the country.
If one has the money for a down payment, the deductions for interest and real estate taxes may be hard to beat, not to mention the tax-free growth in the property's value. And as long as the gain is less than $250,000 ($500,000 for married couples filing a joint return), it escapes the reaches of the tax collector permanently.
Many individuals with the means to capitalize on this opportunity have already seen the benefit of appreciation and should continue to experience a growth in property value.
Individual retirement accounts offer another option for tax shelter that appeals to those unable to tuck away larger amounts of money. Those who are seeking to shelter smaller amounts of income may find it the case that establishing and maintaining a 401(k) plan may not be justified, and could find IRAs a suitable answer.
In that vein, the contribution limits have been increased for those funding IRAs. Starting this year, the contribution limit was increased from $2,000 to $3,000. It remains at $3,000 in 2004 as well, but is again increased by another $1,000 to $4,000 for tax years 2005, 2006 and 2007. In 2008, the limit rises to $5,000. Thereafter, increases will be based on changes in cost of living.
As is apparent, there are tremendous opportunities awaiting those who are concerned about their retirement savings. 401(k) plans, home ownership, and the proper maintenance of an individual IRA provide the best options for a tax shelter.
Goldstein is a tax partner with Foley & Lardner's Del Mar Office and specializes in the taxation of employee benefits and executive compensation.