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Retirement Tax breaks You Need to Know About

As complicated as the tax code has become, everyone really needs a good accountant or tax advisor to help manage and maximize your tax savings. Here is just a condensed version of some topics to start you thinking in the right direction.

You have plenty of new incentives to add to your nest egg going into 2006.. Here’s how recent tax breaks will affect your 2005 return and you’re planning for 2006.

Recent tax-law tinkering has created a host of new tax breaks and higher contribution limits you can use right now to boost your retirement savings and cut your tax bill for 2004 and 2005.

There’s an opportunity to make these benefits even better. But let’s not wait for something from Congress. Let’s make the most of what we have.

Retirement tax credit:

How would you like to make some free money? Since 2003, assuming your income qualifies, you can get a credit of as much as 50% of the amount you stick in a retirement account, up to a $1,000 credit on a $2,000 contribution. That’s $1,000 off your tax bill. It’s like the IRS paid for half your retirement contribution. Not a bad deal!

Put $2,000 in an IRA. If you’re in the 25% bracket, that saves you $500. You also get the $1,000 credit. That means that you’re only out of pocket $500 on a $2,000 investment.

Look at it another way. You’ve made really risk-free, $1,500 on a $500 investment. That’s a rate of return that would even impress Tony Soprano.

This credit is available for elective contributions to a 401(k) plan, 403(b) annuity, a SIMPLE or a SEP. It also covers contributions to a traditional or Roth IRA and voluntary after-tax employee qualified plans.

The credit you receive depends on your adjusted gross income. To get the entire 50% credit, for example, requires your income to be less than $30,000 for joint filers, $22,500 for heads of households, and $15,000 for singles.

Small-employer tax credits this one’s for your boss. Make sure your employer shows his or her appreciation.

Since 2002, your employer can receive a tax credit of 50% of the first $1,000 of administrative and retirement-education expenses incurred for a retirement plan, for each of the first three years the plan is in existence.

If your employer doesn’t have a retirement plan, this is the time to get one. The IRS is willing to fund as much as $1,500 of your employer’s costs. The credit applies to a new defined-contribution or defined-benefit plan, including a 401(k), a SIMPLE or an SEP.

But it’s for small employers only. The credit can’t be claimed by a company with more than 100 employees with compensation of at least $5,000.

Increased contribution limits:

For 2004, the amount you can shelter for retirement has substantially increased. The dollar limitation for defined-contribution plans is up to $41,000 (increasing to $42,000 for 2005). The annual benefit limit for defined-benefit plans has been increased to $165,000 (going to $170,000 in 2005). The compensation limit has grown to $205,000 ($210,000 for 2005). All of these figures will be indexed for inflation.

There’s also a big increase in IRA and Roth IRA limits. For 2004, you can contribute $3,000 a year. The limit will increase to $4,000 for 2005 though 2007. In 2008, it will hit $5,000 and be indexed thereafter for inflation.

Contributions to a 401(k) are now topped at $13,000 for 2004, $1,000 more than 2003. The limit goes to $14,000 in 2005.

Other limits:

• SIMPLE IRA, used by the self-employed: $9,000 for 2004, rising to $10,000 for 2005.
• SARSEP, technically a salary reduction SEP-IRA: $13,000, rising to $14,000 in 2005.
• 403(b) plans for public employees: $13,000, rising to $14,000 in 2005.
• Section 457(b) for nonprofit employees: $13,000, rising to $14,000 in 2005.
• Catch-up contributions

Congress wants you to save for retirement.

Maybe they know something about Social Security we don’t — remember, it’s not their plan. In any case, if you’re age 50 or older, you can make additional allowable retirement contributions. If you have extra money consider it.

For 2004, you can stick another $500 in your IRA and $1,500 in your SIMPLE. And invest another $3,000 in your Section 401(k), 403(b) annuity, SEP or Section 457 plan.

Catch-up contributions don’t affect any other contribution limits. They were drafted into law as a matter of fairness to women, many of whom presumably take time out of the workplace to bear and raise kids. Because of that, they have no earned income for some years and may not contribute to retirement plans.

But men get the break as well, even if he worked continuously. Plus you can make these contributions up until April 15. (In fact, you can contribute to all these retirement accounts until April 15 and use the break on your 2005 tax return.)

Employer-provided retirement advice:

Since 2002, your employer can provide you with retirement planning advice on a tax-free basis. The cost for such advice, or even a full retirement plan, can be deducted by your employer, but won’t count as income to you. Unfortunately, this doesn’t cover tax preparation, accounting, legal or brokerage services.

The bottom line here is that Congress has done a whole lot to encourage you to save for retirement. And they’re right. The more you put in, and the sooner you put the money to work, the bigger the retirement nest egg you’re going to build. And now you can even have Uncle Sam finance the planning professionals to design your retirement strategy.

Money Mangers are always preaching long-term investing. Not only will that give you a better chance at earning more, it’ll also get you a lower tax rate when you sell.

But exactly what rate you get depends on several things, including when you bought the asset, when you sold it, your overall income level and sometimes what tax-code changes are made in the meantime.

Capital Gains:

Currently, capital gains may be taxed at 5 percent, 15 percent, 25 percent or 28 percent, or a combination of rates. These tax levels are known as long-term capital gains and apply to assets that you hold for at least 366 days (more than one year). The long-term capital gain tax generally is much lower than what you pay on your regular income.

In fact, it is a taxpayer’s income level that generally determines which capital gains rate is owed. If your profit pushes you into a higher bracket, you could possibly be taxed at a combination of rates. And you could face yet another rate depending on the type of property you sell.

May 2003 Rate Cuts:

For many years, investors whose overall income put them in the top four faced a long-term capital gains rate of 20 percent, while lower-income investors paid capital gains taxes of 10 percent.

Tax-law changes that went into effect in May 2003, however, lowered the rates by 5 percent each. Most investors, which generally mean folks in the higher income ranges, now find their capital gains taxed at 15 percent.

Remember, each of these is the long-term capital gains rate. In most cases, that means you have to hold an asset for more than a year before you sell it. If you cash it in sooner, you’ll be taxed at the short-term rate, which is the same as your ordinary income tax level and could be as high as 5 percent on 2005 returns.

5 percent rate:

This capital gains rate applies to taxpayers in the 10 percent or 15 percent income tax brackets. They will pay a maximum 5 percent long-term gains rate on property held for more than a year.

Lower-income investors get an even better investment sale deal in 2008. That year, these filers will pay no tax on sales of long-term holdings. The 5 percent rate still applies to a portion of your gains even if your asset sale pushes you into a higher bracket. For example, if as a single filer your taxable income was $25,000 but you netted another $7,000 from a long-term stock sale, some of that gain would still be taxed at the lower 5 percent capital gains rate even though technically you were bumped into the 25 percent tax bracket.

In this case, $29,700 (the income ceiling for the 15 percent bracket) minus your ordinary income of $25,000 gives you a $4,700 capital gains cushion at the 5 percent level. Only the remaining $2,300 of gain would be taxed at the 15 percent rate applicable to your new, higher tax bracket.

2005 tax-breaks to consider:

For the last several years, owners of the increasingly fashionable hybrids have been able to deduct $2,000 of the purchase price of these vehicles, which combine an electric motor with a gasoline-powered engine to produce fewer emissions.

How much this actually cuts your tax bill depends on your tax bracket. For someone in the 33-percent bracket, the $2,000 deduction will mean $660 less in taxes; for a 15-percent taxpayer, $300.

The Clean Fuel Deduction:

Most clean-fuel eligible motorists will use the deduction because they drive hybrids. But owners of fully electric vehicles get an even better break: a tax credit up to $4,000.

The hybrid deduction allows you to reduce your taxable income, which generally produces a smaller tax bill when all the figuring is done. But with a tax credit, once you determine what you owe, the credit will directly cut your tax bill, possibly even wiping out any taxes you owe.

Credits are more valuable than deductions, since credits reduce your tax bill dollar for dollar. Deductions, on the other hand, simply reduce your taxable income amount.

Hybrid vehicles that Qualify:

Hybrids are the most popular vehicles eligible for this tax break, and the Internal Revenue Service has issued a list of qualified vehicles that taxpayers can claim:

• Ford Escape Hybrid — model years 2005 and 2006
• Mercury Mariner Hybrid — model year 2006
• Lexus RX 400h — model year 2006
• Toyota Prius — model years 2001 through 2005
• Toyota Highlander Hybrid — model year 2006
• Honda Insight — model years 2000 through 2005
• Honda Civic Hybrid — model years 2003 and 2005
• Honda Accord Hybrid — model year 2005

But the clean-burning-fuel tax deduction also applies to vehicles that operate on natural gas, liquefied natural gas, and liquefied petroleum gas, hydrogen or any other fuel that’s at least 85-percent alcohol.

Even better, the tax break is claimed directly on Form 1040. You do have to file that longest form, but there’s no Schedule A to complete or income thresholds to meet. Simply enter the amount on line 36 of the return and write “clean fuel” on the adjacent dotted line.

Restrictions for what you can write off:

The deduction does have some limits. It’s a one-time deduction, not one you can take each year for as long as you own the car.

Only the car’s original purchaser can claim the tax break. So while your pre-owned Prius may still save the ozone layer, it won’t save you on your taxes.

And the deduction applies for the year you put the car on the road. If you bought hybrid years ago, but neglected to claim the deduction on the appropriate tax return, you might be able to claim the deduction on an amended tax return.

Generally, you can file an amended return within three years of your original filing date, including extensions you were granted. So if you bought an eligible hybrid vehicle in 2002 but didn’t claim it on the return you filed in 2004, check into whether refiguring that year’s return could get you some tax money back. Buying a car? It’s time to think green!

Terms you need to understand:

Adjusted gross income:

AGI, is all the income you receive over the course of the year such as wages, interest, dividends and capital gains minus things such as contributions to a qualified IRA, some business expenses, moving costs and alimony payments. The adjusted gross income is the first step in calculating your final federal income tax bill.

Tax credits:

Tax credits are much like credits you get from a store. After you figure your tax bill, you can use the credit to reduce the amount of the check you must write to Uncle Sam. Tax credits are more valuable than deductions because they directly cut the amount of tax you owe, rather than reducng the amount of taxed income. A $200 credit, for example, will turn a $1,000 tax bill into only $800. And a few even could give you a refund you weren’t expecting.

Deductions:

Deductions are expenses that the Internal Revenue Service allows you to subtract from your AGI to arrive at your taxable income. In most cases, the lower your income, the lower your tax bill. If, for example, a single filer has income of $35,000 and $5,000 in deductions, then he would pay taxes only on $30,000. The IRS offers all filers a standard deduction amount. Some other deductions, such as student loan interest, moving expenses, deductible IRA contributions and alimony payments, also are listed directly on the 1040A or long Form 1040.

But the term is most commonly associated with the itemized deductions that are claimed by taxpayers who file Schedule A. This is a fixed dollar amount that a taxpayer can subtract from his or her income. The standard deduction is available to all filers and is determined by the taxpayer’s filing status.

The amounts change each year because of inflation adjustments. This deduction method is used by most taxpayers and eliminates the need for them to itemize actual deductions such as medical expenses, charitable contributions or state and local taxes.

Your AGI (Adjusted Gross income) includes all the income you received over the course of the year, such as wages, interest, dividends and capital gains, minus things such as business expenses, contributions to a qualified IRA, moving expenses, alimony and capital losses, interest penalty on early withdrawal of bank CD certificates, and payments made to retirement plans such as SEP and simple IRAs.

IRA contributions:

If you are younger than 50, IRA contributions are limited to $4,000 a year in 2005 and 2006 If you’re 50 or older, the limits are $4,500 in 2005 and $5,000 in 2006.

Contributions are classified as either tax deductible or nondeductible.

Contributions to a traditional IRA are tax-deductible if you are not covered by your employer’s retirement plan. Even if you do participate in a company pension or 401(k) plan, you still may be able to deduct contributions to a traditional IRA depending on your income and filing status. Contributions to a Roth IRA are not deductible. There is also an education IRA that may be worth looking into. It’s called the Coverdell Education Savings Account. You can’t deduct the Coverdell contributions from your income taxes, but earnings are tax-deferred and qualified withdrawals are tax-free.

I hate all this mumbo jumbo don’t you. How much simpler life would be with a flat consumption tax. Now I said it and I feel just a little better.

For more information do a Google Search under “Retirement Tax Advantages. The one site with some of the best overall information is http://www.bankrate.com. The Motely Fool is good and the Wall Street Journal always does a good job. If you are a member of AARP you can beat their broad range of services and advice.