“Deferring your income is the best possible tax strategy for building wealth.”

“An employer’s matching contribution to your 401(k) is equivalent to a pay raise.”

“There are important differences between a standard IRA and a Roth IRA, but both allow you to accumulate investment earnings on the deferred amount tax-free.”

p> The simplest tax planning strategy that individuals of any income level can adopt is to defer their income. It’s something like stashing money in a savings account that Uncle Sam can’t touch and then paying a lower amount of taxes in absolute dollars and potentially in a lower overall rate of taxation on the remainder. Deferring your income is the best possible strategy to adopt for two reasons. One, you don’t pay taxes on a portion of the income now. Two, if you systematically invest what you defer, it will be worth many times the original amount when you finally withdraw it.

In the last twenty years, a variety of income deferment options have become popular among baby boomers. There are many reasons for this. Some of them include our doubts about the reliability of the social security system and our desire to live well, not just comfortably, after we retire. The fact is that average life expectancy has increased so much that most of us can reasonably plan on 20 to 30 years or more “in retirement.”

Here is a brief description of some of the more common ways you can defer your income. I talk about other tax-deferment options, including Variable Annuities, Variable Universal Life Insurance, Estate Planning and Charitable Foundations elsewhere.

401(k) Plans

A 401(k) plan permits employees to save a certain portion of their income by making a contribution to the savings and investment account designated for this purpose by their employer. The biggest advantage is that this income is not taxed as are your normal earnings. In 1998, the tax code specified a limit of $10,000 in pre-tax income. Some plans also allow an after-tax contribution as well. Both the money you contribute and the revenue it earns accumulate tax-free until you withdraw it. You can withdraw the money, without penalty, starting at age 59 1/2. When your employer contributes matching funds to your 401(k), it is equivalent to a tax-free pay raise and an extra inducement for you to contribute the maximum amount you can.

IRAs

An Individual Retirement Account allows some taxpayers to defer up to $2,000 of their annual income, or $4,000 for a married couple. These plans are restricted to workers who aren’t already covered by an employer’s retirement plan or who are, but whose adjusted gross income falls below a certain level. Like 401(k) plans, your contribution and your earnings accumulate without taxation and you may withdraw the funds without penalty starting at age 59 1/2. IRAs also permit early withdrawals, without penalty, for specific reasons including first home purchases, qualified higher education, and medical expenses that exceed 7.5% of your adjusted gross income.

Roth IRAs

Roth IRAs are funded solely with after-tax income but the earnings on the account are not taxable. Unlike standard IRAs, the Roth IRA doesn’t require distribution after age 70 1/2 and you can still make contributions to the Roth IRA after this age. Furthermore, you may be able to withdraw funds from the Roth IRA five years after the initial contribution or conversion for certain qualified reasons without paying a penalty or taxes. For instance, funds you withdraw in case of disability or for a first-time home purchase are exempt from both. Funds you withdraw to cover specific medical or higher education expenses are taxable, but exempt from penalties.

Married taxpayers can contribute to a Roth IRA if their adjusted gross income (AGI) does not exceed $150,000. The income limit for single taxpayers is $90,000.

Keogh Plans and Simplified Employee Pensions (SEPs)

Self-employed individuals use these two plans to defer their income. Like IRAs, both the amount of the contribution to the Keogh or SEP and the accumulated return on that contribution are not taxable. The maximum annual contribution to a Keogh is $30,000 or 15% of the net income from self-employment, whichever is less. The maximum contribution to a SEP is 15% of net income on incomes up to $150,000. One advantage of a SEP over a Keogh is that you can contribute to a SEP any time up to the date you must file a tax return on that income. With either plan, you benefit the most from the earliest possible contribution since the earnings accumulate tax-free in these accounts.