After seven years at Howard University, including four at the medical school, and a four-year residency at King Drew Medical Center in Compton, California, Dr. Adrienne Alston bought an ophthalmology practice in Harbor City, California. This shining moment, however, was about to be eclipsed by Uncle Sam and the Internal Revenue Service. Alston suddenly found herself making over six figures and in the top tax bracket, which meant a combined 45.4% federal and state tax bite.
Thanks to new laws, Alston’s deduction options were whittling away, so she began seeking advice on tax-advantaged savings vehicles.
That was 11 years ago. Today, the 41-year-old has saved more than $150,000 through tax-deferred investing. She stashes away about 20% of her pre-tax income, mainly through a Keogh for herself and her five- member staff.
Like Alston, millions of Americans seek ways to stash money in tax- deferred vehicles such as 401 (k)s, individual retirement accounts (IRAs) and annuities, or tax-free instruments, such as muni bonds and Treasury securities. And with good reason: income taxes can chomp away at a third of your investment income.
By reducing your tax bite, you could save 15-40 cents on every dollar you earn, depending on the tax bracket you’re in. That’s not including money you could save on your state income taxes. Moreover, investing in tax-free and tax-deferred vehicles increases the value of your money over time–funds that otherwise would have gone to Uncle Sam.
“Today’s environment underscores the increased importance of tax exemption,” says Pierre Dunagan, associate vice president of investments at Dean Witter Reynolds in Matteson, Illinois. “Federal, state and local taxes are on the rise,” he adds, pointing out that the top personal tax bracket has been raised within the last 18 months in several states.
There are key distinctions between tax-free and tax-deferred investing. Tax-free, or tax-exempt, investing means exactly that: no tax due now or in the future. On the other hand, tax-deferred investing means that no taxes are due now but will be due in the future when your money is withdrawn or assets sold. Qualified retirement plans, IRAs, investments within life insurance policies. Series EE bonds, deferred compensation plans and annuities are all ax-deferred.
The benefit of deferral is the fact that no taxes are paid until your money is withdrawn, usually at retirement age, at which time you’ll likely be in a lower ax bracket. Until then, your earnings are reinvested and compounded with nary a penny to pay in taxes along the way.
Whether you’re in your 20s or 40s, just starting to work or close to retirement, you’ll find that tax-deferral offers significant benefits. Still, figuring out the best investments is not easy. Here are some helpful hints from the experts.
THE 411 ON 401 (k)s AND IRAs
Those in the 28% or above tax bracket, who have 20 or more years before reaching retirement age, should invest in their company’s 401(k) plan. This defined contribution plan is an ideal way to stash away some of your pre-tax income. You can elect to take a salary