Thousands of investors sunk billions of dollars into these equities, seeking tax breaks. However, they sacrificed their rate of return for tax savings. Now, there are fewer tax shelters that exist, and fewer people using them to their advantage! Hopefully, after reading this, you won’t be one of them.

IRAs

These accounts are most commonly used to accumulate wealth for many reasons. First, they allow you to grow your money at a taxdeferred rate. Second, you don’t have to begin taking money out of the account until you reach 701/2 years of age. Third, you can deposit up to $3000 per year before tax. (You deduct the amount you contribute from your taxes.) Although $3000 doesn’t sound like a great deal of money, over time it does accumulate. Plus, the more money you contribute each year, the faster it will grow.

Roth IRAs

The main difference between IRAs and Roth IRAs is that the Roth contribution isn’t tax-deductible. However, it’s a great way to shelter your money and let it grow tax-deferred. The Roth is also subject to the same maximum contribution limits as the traditional IRA, but when you begin to take the money out, it will be distributed tax free. So, while contributing to a Roth won’t save you money on your tax bill currently, it could save you, potentially, a large amount of money during your retirement.

401(k), 403(b), and 457 Accounts

Most people are familiar with these types of retirement accounts that are offered by employers, typically large companies, and tax-exempt organizations, such as most nonprofit organizations, hospitals, and schools. The beauty to these accounts is that they help lower your current taxable income. When you invest in a 401(k), 403(b), or 457, the money comes out of your paycheck before the tax is taken out. Then when the tax is calculated, it is done so on the remaining amount of the paycheck. Therefore, if your paycheck is for $1000 per week, and you divert $100 each pay period to your retirement account, you are only taxed on the remaining $900, thus lowering your taxable income and tax due.

This year, the federal government has increased the amount of money you can invest in a 401(k), 403(b), and 457 to $11,000 per year. This number will continue to increase until the year 2006, when it reaches $15,000 per year. Therefore, you could potentially reduce your taxable income by up to $11,000 this year!

SEPs

SEPs, or simplified employee pension plans, are retirement plans that use IRAs or IRA Annuities as the receptacle for contributions. SEPs are often attractive to small business owners because of the reduced administrative tasks and expenses. Documentation, reporting, and disclosure requirements are simpler for SEPs than for qualified plans. However, in exchange for simplicity is the loss of flexibility. For example, under an SEP, all employees must be covered as long as they meet specified requirements, and the benefits must be fully vested at all times. SEPs allow employers to make contributions to an employee’s retirement without utilizing a more complicated retirement plan, like a 401(k). You can use SEPs if you are incorporated or if you have selfemployment income, so check with your CPA to see if you qualify to establish a SEP.

From a design perspective, the SEP is quite similar to the profit-sharing plan. The plan may also allow employees to make pretax salary deferrals, like in a 401(k) plan. The maximum employer contribution to the SEP is 25 percent of the compensation of all employees eligible to participate in the plan. If an employer sponsors several profit-sharing plans and SEPs, all plans are aggregated under this rule. The maximum amount that can be allocated to each participant from employer and employee contributions is the lesser of 100% compensation or $40,000 (indexed for 2002). The cap for the compensation that applies to SEP is 200,000 (indexed for 2002).

Annual  income = $75,000
25% of  $75,000 = $18,750
SEP contribution = $18,750
Annual  income = $325,000
25% of  $325,000 = $81,250
SEP contribution = $40,000 (Maximum Limit)

Keogh plans

The term Keogh Plan refers to an employer-sponsored plan that covers a self-employed individual such as a partner in a partnership, an individual member of limited liability company, or a sole proprietor. The plans are named after a congressman that first introduced legislation allowing self-employed individuals to sponsor these types of plans. For many years these plans were subject to more stringent rules and limits on contributions than plans sponsored by corporations. Today, all types of business choose from among the same group of quilified plans. A sole proprietor, instead of establishing a Keogh Plan, establishes a profit-sharing plan, defined-benefit plan, or other plan from the array of tax-advantaged retirement plans. The only distinction that still exists is the manner in which self-employed individuals detrmine their income for purpose of applying the limitations.

The self-employed indviduals’ contributions or benefit is based on net earnings instead of salary. Note that net earnings can be determined only after taking into account all qualified business deductions, including the deduction for the retirement contribution. Therefore, the amount of net earnings and the amount of deduction are dependent on each other.

Profit-Sharing Plans

The maximum employer contribution to the profit-sharing plan is the same as for an SEP, that is 25 percent of the compensation of all eligible employees. For these plans, though, you need to establish a vesting schedule, which will allow you to phase your employees into the plan over time.

For example, you participate in your company’s profit-sharing plan. After two years there, you decide that it would be best if you were to find another job. Because of your company’s vesting schedule, you may only be able to take a portion of your profitsharing plan with you; typically after two years it would be 40 percent. You are always able to take 100 percent of your contribution. The 40 percent only refers to the employer’s contribution. Generally, after five years of participation, an employee is 100-percent vested and would be able to take all of the proceeds from the plan and roll it over into another plan. Vesting schedules often work as a deterrent for employees who may be prone to frequent job switching.

Money-Purchase Plans

These plans are also part of the Keogh plans and can be set up separately. The difference between the profit-sharing and money-purchase plans is that employers need to establish a set percentage of the payroll that will be deposited into this account. These plans are rigid and don’t allow for any flexibility. While your employer may be able to deposit up to 25 percent of payroll, whatever he chooses he needs to stick with. Therefore, if he decides that he will contribute 20 percent of payroll, then he will continue contributing 20 percent. The maximum annual contribution that an employee can receive is the lesser of 100 percent of salary or $40,000.

Annuities

Annuities are a great tax shelter because there is no limit to the amount of money you can invest in an annuity during a given year. However, there is no tax write-off for this investment. The money simply grows on a tax-deferred basis until you annuitize the account. Plus, within variable annuities you can switch between the different annuity subaccounts at no cost and without triggering any type of taxes. I regularly recommend annuities to clients who would benefit from tax-deferred growth of their money. I once read an investment book where the author cautioned against investing in annuities because of the surrender. However, I disagree with those who believe that annuities are a poor investment choice. There are many good reasons for investing in annuities and I’m not against recommending annuities if I believe that they are good for the client.

Life Insurance Policies

There may come a time when either a financial advisor or an insurance agent tries to sell you on the idea of using a life insurance policy as a means to accumulate the cash value on a tax-deferred basis that can then be used for retirement. This isn’t a good idea because the policy is insurance and it’s an expensive idea. When you pay the premium on the policy, a part of it pays the cost of insurance. The rest then goes into a separate account where it grows tax-deferred. Therefore, just because you are paying in $200 per month doesn’t mean that the whole amount is going to be invested. Your cost of insurance could be $100 out of that $200, leaving just $100 per month being invested. It’s far better to direct that $200 into a different account where the whole amount can grow.

There are many financial advisors and insurance agents who would like you to believe that life insurance is an investment vehicle. Yes, life insurance does allow your money to grow tax-deferred. However, these are insurance policies first and foremost. If you are considering purchasing a life insurance policy make sure that you need the insurance. Do not purchase one because you have been told that they are great investment tools. Life insurance policies are good for estate planning, and I have recommended them for that purpose, but never for an investment choice.

These investment choices, however, aren’t totally fail-safe. Rather, they are only as good as the underlying equities are. While you should definitely remember to try and save as much on your tax bill as possible, don’t sacrifice investment results and rates of return only because you are saving on your tax bill. If you decide that another security offers a better track record and potential return, but is currently taxable to you, it may be a better idea to invest in that security rather than the tax-deferred accounts.

Another important factor to tax shelters is that the government tries to not let you take advantage of them if your income is substantial. Contributions to Roth IRAs are phased out at certain income levels, as well as the tax-deductibility of traditional IRA contributions. Before you jump in and decide that one of these investments is a good idea for you, you need to know if it will be beneficial to you in the long run. Plus, you need to see if you will even benefit from the tax deduction, or if your adjusted gross income is above the required maximum.