Three Cheers for Tax Shelters!

By: Nilus_Mattive

Okay, before you get the wrong idea … today’s article is not going to talk about hiding money in foreign countries or any other strategy that is either suspicious or outright illegal.

Cheating on your taxes is hardly something I would advocate, let alone celebrate.

Sure, I think a lot of our money is wasted because our politicians are the biggest spendthrifts on the planet. And I absolutely know there are simpler, fairer ways to run our internal revenue system than the way we’re currently doing it.

But for this year at least, we’re stuck with the same old convoluted mess of forms, worksheets, and publications. I ought to know since I just got done with my return and it included TEN different forms and schedules that needed to be filled out. (Yes, like a stubborn mule, I insist on doing my own taxes every year.)

At any rate, we can’t change the system nor should we let our fellow citizens suffer while we avoid paying our fair share, even if the whole thing stinks.

However, we can — and must — do everything within the letter of the law to reduce the amounts we owe as individuals. Especially when those same steps will also ensure better retirements for ourselves or better educational opportunities for our children and grandchildren.

The way I look at it, we’re simply fighting paper with paper … and using the system as best we can. So without further ado, here are …

Four Simple Tax Shelters That You Should Consider Today!

#1. 401(k) plans — Most employers offer these retirement accounts, and they’re a great way to keep money away from Uncle Sam. That’s because whatever you contribute is taken out of your pre-tax earnings. Not only does that mean you are deferring taxes on the amount contributed, but you also might be bumping yourself into an overall lower tax bracket.

For 2010, most people can put away as much as $16,500. And if you’re over age 50 you may be eligible to contribute an additional $5,500 in catch-up money!

Meanwhile, your investments grow tax-free until you cash out during retirement. Add in the fact that many companies are willing to match some of your contributions and you can see why I think 401(k) participation is a complete no-brainer.

I would also note that self-employed folks should take a serious look at a special class of these accounts, called Solo 401(k)s. They carry MUCH higher contribution limits (as high as $49,000 for high earners under age 50).

#2. Individual retirement accounts (IRAs) — Whether you have access to a 401(k) or not, you can also contribute to an individual retirement account every year. The only provisions: You must have earned income and it must fall within a certain threshold (see my table for the details).

Important: The reason I’m still citing 2009 numbers is because you can still fund an IRA for 2009 up until April 15th! That’s true even if you’ve already filed your taxes, too. In fact, you can even use any tax refund you received.

So if you haven’t done so already, and you’re eligible, strongly consider an IRA today!

For both 2009 and 2010, investors can contribute up to $5,000 annually to their IRA accounts. If you’re at least 50 years old, you can also take advantage of a special catch-up provision and stash away another $1,000.

Just note that you cannot max out both a regular and a Roth IRA in the same tax year. Your total contributions to all IRA accounts (not counting rollovers and such) must fall within the ranges I just cited.

Which is the better choice — a Roth or a regular IRA? Only you can decide based on your eligibility, age, goals, etc. But I will say that the Roth IRA has a few advantages including no required withdrawals, no age restrictions, and no more taxation of any money earned in the account … EVER!

#3. Coverdell Education Savings Accounts — If you have a child or grandchild you’d like to help out, this type of account is a nice little tax-shelter for them. You can put in $2,000 every year for the minor’s education (up until their 18th birthday).

Coverdells operate much like Roth IRAs (they were formerly known as Education IRAs). As long as later withdrawals go to qualified education expenses, your original contributions and any investment returns are not taxed.

The beneficiary of the account has until age 30 to use the funds. After that point, they must either withdraw the money and pay taxes plus a 10 percent penalty or roll the funds into a new Coverdell account for another beneficiary. But in my book, this is a terrific tax shelter for just about any child in your life.

#4. 529 Plans — Again, these are great for parents, grandparents, or anyone else looking to help put a child through college. Like Coverdell accounts, they allow contributions to grow tax deferred. Plus, distributions will be tax free as long as they go to qualified education costs (in this case, it’s only post-secondary education purposes).

In addition, depending on the plan, the future student is not the only one who reaps tax benefits … the contributor can too! See, 529 plans are sponsored by individual states and some will allow residents to write-off the money they put into a plan against their income taxes. Considering that some 529s accept as much as $300,000 in contributions over the life of the account, your tax benefits can be extremely significant.

Also Remember That Dividends Will Still Get You a Major Tax Break Through 2010!

I’m not going to rehash all the reasons I love dividend stocks today (especially for the kind of accounts I described a moment ago!).

Instead, I just want to point out that most dividend payments continue to get taxed at a much lower rate than other investment earnings because of the Jobs and Growth Tax Relief Reconciliation Act of 2003.

For most people, the tax rate on qualified dividends is now just 15 percent. Investors in a lower income bracket actually pay no tax on their dividend income. And these advantages will remain in place at least through this year.

The advantage of this tax break to a taxable income portfolio can be considerable. Say you have $100,000 invested in dividend-paying stocks with an average yield of 4 percent. That’s $4,000 in dividend income every year.

If those payouts were taxed at your ordinary income rate, you could end up giving back as much as $1,400 in taxes (based on the highest bracket of 35 percent).

In contrast, under the lower rate, you would owe only $600. That’s an additional $800 in your pocket!

Based on our country’s current fiscal condition, I won’t guarantee that this unique advantage will continue beyond this year.

But I’m almost certain that — no matter what you and I think about it — overall tax rates are going to continue creeping higher in the years ahead.

So I strongly urge you to consider taking advantage of every legal means you can to shelter your wealth and watch it grow with as little interference from Uncle Sam as you can.

And if you have yet to wade through all those 2009 forms yet, you better get crackin’!

Best wishes,

Nilus

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