Tax Shelters for Retirement Savings

When most people think of tax shelters, they imagine Swiss bank accounts or gold hidden in a vault in an island country. However, contrary to popular belief, tax shelters are more commonly a very proper function of the tax code.

Governments around the world use tax shelters as a way to encourage specific goals. For instance, if a government wanted more home ownership (as the United States does), then it would provide a tax advantage for purchasing a home. If it wanted people to save more for retirement, it would give investors a tax advantage for saving for retirement.

There are any number of retirement tax shelters, most of which people know exist, but not to what degree. We'll analyze some of the most popular tax shelters in the United States.

Golden Nest Eggs: 401k and IRA


The 401k and Individual Retirement Account (IRA) are two tax shelters most people view as proper retirement savings accounts. However, even though most know that they are tax advantaged, few use them to their maximum potential.

The maximum contribution for 401k programs comes to a whopping $16,500 per year. For people who are 50 or older, this maximum is even greater. Known as a “catch-up” contribution, retirement savers who are older than 50 can contribute an additional $5,500 over and beyond the $16,500 maximum to their 401k.

As for tax advantages, a 401k can receive pre-tax contributions, or post-tax through a Roth 401k.  Pre-tax 401ks require the tax burden be paid on withdrawal, while returns from a post-tax Roth 401k are taxed at deposit and tax-free on withdrawal.

An IRA allows for maximum annual contributions of $5,000 for people ages 49 and younger and $6,000 for people 50 and older. Just like a 401k, these amounts can be added to a retirement plan as pre or post-tax, regular or Roth IRAs. The Roth IRA allows for tax free withdrawals, making it a great tax shelter; however, some opt for a pre-tax IRA, thinking they'll be in a lower tax bracket at retirement.

Few investors ever extend themselves between these two accounts. Those younger than 49 can save as much as $21,500 for retirement in a tax advantaged account each year, excluding employer match. Those older than 50 can save as much as $28,000 per year with an IRA/401k combined tax shelter. While that seems like a lot of money to be invested, there may be better tax shelters that fit your own needs.

Real Estate: More than Shelter


Real estate purchased outside of a retirement account is an excellent tax shelter. For one, most investors find that virtually every expense is tax deductible. Interest payments on investment property can be deducted, as well as the property taxes on the residence.

In addition, while a tenant might actually pay for the entire cost of the home over time, the investor earns all the depreciation. A residential piece of property is depreciated over 27.5 years in straight line. Thus, a $100,000 improvement (in the structure, but not the land, as land cannot be depreciated) would depreciate at a rate of $3,636 per year, a cost that can be written against earned income.

Part of the tax shelter benefits of real estate have been addressed by government, but most people, especially those that live in the midwest, where wages and cost of living are lower, have plenty to gain by sheltering their income with real estate. Plus, since real estate requires only a small down payment, there is little out of pocket expense involved.

Life Insurance Contracts


More and more retirement planners are turning toward life insurance contracts as a tax shelter for people who have already maxed out other investments and are looking for solid returns with the benefit of having life insurance.

Once an investor passes the period where life insurance is necessary, the cash value of whole-life policy can be drawn out of the policy. Unlike other products, where withdrawals are taxed, whole-life policies treat any withdrawals as if they were a loan. This “loan” of sorts, is paid upon death, when the remaining value of the policy is used to cover any extracted value.

In addition, since the IRS section on life insurance treats each payment as a return of capital, even those who draw more from a policy than they paid in premiums will not be taxed. Thus, if an investor put $100,000 in a life insurance policy through monthly premiums but withdrew $120,000 of cash value, the $20,000 profit is not a capital gain. There are few tax shelters that provide protection for guaranteed returns.

Health and Care Insurance


Health and long-term care insurance may not be first in line on the retirement plan, but they are two products that make excellent tax shelters. While these two products kick in for employees at 7.5% of adjusted gross income, the self-employed can deduct them directly from income, regardless of what percentage of income they reach.

Long-term care insurance should certainly be part of anyone's retirement plan, regardless of the tax advantages. Being insured against long-term care costs means more consistency in your retirement plan. For many people, long-term care costs eventually eat every dime of their retirement savings, so why not protect yourself with insurance, and take part in a tax shelter all at the same time?

Post-Retirement Tax Shelters


After finding the best tax shelters for your retirement savings, there are a number of ways your annual tax burdens can be reduced. Many retirees with sufficient savings choose to fund savings vehicles or the college education of a family member. Doing so allows for retirees to draw more income against their savings vehicles to distribute tax-free to the advantage of a family member.

This final part is the best part of tax shelters and retirement savings. When your financial needs are met for your post-retirement life, the savings you have accrued can be used to help the generations that follow you, and you can do it all tax-free for both them and yourself with proper planning.
Tim Ord
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