Tax Shelters are Back and This Time They're Legitimate By Stephen J. Butler Archives
Many years ago, MEDICAL ECONOMICS magazine ran an article about the number of doctors who were serving time in minimum-security federal prisons for tax evasion. For the most part, these were professionals who had developed the habit of accepting cash payments from patients and not reporting it. The IRS, when auditing, just asked to see a month of appointments -- any month - and they would systematically call all the patients seen that month to ask if they had paid with cash or a check. After that, only the combination of simple arithmetic and honesty stood between the doctor and the slammer. And then there was Jerry on the old Bob Newhart show who returned his living room couches to the waiting room of his dental office. He was being audited and had to prove that the furniture costs he had deducted were clearly for business purposes.
Thanks to the new pension laws enacted for 2002, older professionals and small business people can relax. They can report all income and take just legitimate deductions. Why? Because income on which they would prefer to defer taxes can be contributed into a retirement plan. Anyone over fifty years of age is close enough to retirement to be concerned about the reversal of fortune they have experienced over the past two and a half years. Today, some aggressive pension planning can offer the corrective measure that will get those original retirement income projections back on track.
There are three stages of annual contribution limitations. The first is the well-known 401(k) annual contribution limitation of $12,000 for folks over fifty this year. In four years, that maximum will have graded up to $20,000. The second maximum is the total of $40,000 which is the combined total contribution of both the voluntary 401(k) and employer contributions. The third stage is that created by a defined benefit plan allowing the employer to fund for a specific retirement benefit. This type of plan could allow contributions that are "off the charts" (over $200,000 per year, for example) depending upon the business-owner's age and current income.
The application of these different retirement plan alternatives hinges on the mix of employees and their ages relative to that of the business owner or professional who hopes to maximize his or her contribution.
In simple terms, here's how these more aggressive plans work: A business owner who wants a $160,000 per year retirement benefit is allowed to accumulate approximately $1.9 million in a retirement plan. Today's annuity tables have shown that this is the amount needed to guarantee a lifetime income of $160,000 per year (the maximum allowable benefit.) While most retirees would elect to live on any interest earnings from this money and maintain the principal, anyone could actually purchase an annuity from an insurance company that would guarantee $160,000 per year for life even if they live as long as Senator Strom Thurman.
For a fifty-year old person to accumulate $1.9 million in fifteen years, he or she would have to contribute about $82,000 per year assuming a compound rate of return of 6% interest on what they contributed. In other words, $82,000 per year earning 6% accumulates to $1.9 million. If the same person waited until age 58 to start the annual contribution cost with just seven years of time would be $226,000 --- all tax-deductible. Contributions of $226,000 each year for seven years and earning 6% would accumulate to $1.9 million.
A qualified retirement plan has to meet requirements that prevent it from discriminating in favor of company owners or highly-compensated employees. Therefore, the plan has to make an equivalent, but proportionate promise to all of its eligible employees. This means that an employee making $40,000 per year at age 30 would get the same ultimate retirement promise, but the arithmetic would be substantially different. This person has 35 years until a projected age 65 retirement. The funding objective is $475,000 - the amount required to fund a lifetime income of $40,000 beginning at age 65. The annual cost to fund this benefit is about $4,000. If the employee was only age 25 with 40 years to accumulate, the annual cost would only be about $3,000. These plans can be combined with 401(k) plans, so these younger employees can still contribute all or any portion of their annual 401(k) maximums.
A growing subset of our society (two-thirds of all California workers) is working in non-traditional employment modes (independent contractors, part-time jobs for spouses, etc.) that open the door to many creative uses of these new retirement plan opportunities. A 55-year-old independent contractor making $60,000 could defer $30,000 into Gearloose" types who read Mechanics Illustrated and who would figure out ways to design and market retrofitting devices to bring hybridization to existing vehicles.
An immediate and substantial gas tax, then, is something I see as a silver bullet that would wake us up and immediately set us on the road to a long-term solution. It would have the same shock effect as that fateful morning in the 70's when we all got on the freeway and couldn't go more than 55 miles an hour. There might be other positive, unintended consequences as well. Where sheer anarchy reigns on our freeways today with average speeds of 75-80 mph, people might slow down a little just to save fuel. Others might think first before mindlessly buzzing around an otherwise peaceful lake on a jet ski. The list is endless.
Why is this "hot potato" the subject of a retirement column? Because retirees and those approaching retirement generally don't have some macho image they need to reinforce by driving a vehicle with capabilities and power they never use. "Not that there's anything wrong with that," I'm quick to add. It's just that the rest of us shouldn't have to pay for it. It's a zero sum game. If we double the price of gas by adding a tax, we can use that money to pay off or protect oil rich countries instead of using income taxes or government borrowing the way we do today. For retirees who tend to drive less, the gas tax will represent a better deal than higher income taxes.
As a group, retirees are a powerful political force and perhaps the only national constituency with muscle enough to counteract the special interests that currently stand in the way of an effective energy policy. Retirees have "been there and done that." Older people know what they are doing. It's not accidental that people in their 70's around the world are being elected to leadership positions as heads of governments. The rest of us, by comparison, are collectively like Toad when he is "fulfilling his instincts, living his hour, reckless of what might come to him." Cheap gas just contributes to our national delinquency.
(Mr. Butler enjoys a collection of high-powered automobiles, motorcycles, and boats. He is a modern-day Toad of the highest order who hopes someday to become a "recovering gasaholic.")
Correction: Last week's column pointed out that capital gains on the sale of a personal residence would be tax-free if invested in another residence. In fact, the first $250,000 is tax-free regardless of how the money is spent.
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