Sí, Money! Vol. 1, No. 2  December 2007   http://simoney.us
by Michael Grodsky

Although the slithy toves may endlessly gyre and gimble in the wabe, as the end of the year approaches your opportunity for setting up a new retirement plan is drawing to a close. When Lewis Carroll penned the line Beware the Jabberwock, my son! he might as well have been thinking of the IRS taking its tax bite from your behind.

When it comes to saving for the future, make sure you see the big picture. In my last column I waxed and whined over the concept of the Time Value Of Money, describing how compound interest can generate surprising results given enough time. This column goes one step further: If you can choose to defer spending today so you’ll have more tomorrow, what structures are available? One investment strategy is that self-employed artists can shelter income and defer tax liability through traditional retirement plans. Quoted contribution amounts and other numbers are based upon the 2007 tax year (all tax references sourced from http://irs.gov).

If you haven’t yet considered a plan, now is a good time to take action. If you already have one, bravo for you! If your finances have changed this year, check if your existing plan is still is the best fit for your circumstances. With increased income you may be able to increase contributions, and thus shelter more income from taxation. Contribution maximums range from $4,000 to $180,000 for 2007, depending on your income, plan type, and age.  Notice I didn’t consider that your income would be less? Hope springs eternal!

What are the benefits of setting up a tax-deferred retirement plan versus simply saving on your own in a taxable account?

First let’s consider what happens if you save on your own. Jill had a dream in which her future self wasn’t happy, not one whit, with her progress in building a nest egg.

Miraculously, she found $4,000. If she’s in the 33% tax bracket, she had to earn $5,970 to get that $4,000 in her pocket. If she now invests in a CD or savings account she’ll continue to pay taxes on the interest earned each year. At least that’s better than nothing, but is there a more productive alternative?

The incentive for saving in a retirement plan is that contributions may be deductible from your income, and earnings grow tax-deferred. Maybe we should call it your “re-engagement account,” because the idea of retirement probably doesn’t apply to you. Point is, imagine a future day when you can choose whether to work, and yet maintain your lifestyle. Maybe you can get all the way there, maybe not, but with both a goal and a plan you can assess your progress along the way, make changes, and adapt. A tax-deferred retirement plan is a good place to start.

Let’s compare the result of saving $4,000 on your own versus saving in a pretax retirement account, assuming a single artist with taxable income of $50,000 from all sources, such as from both art production and teaching.

SAVING ON YOUR OWN
Taxable Income: $50,000
Tax Rate: 25%
Tax: $12,500
After Tax Income: $37,500
Contribution to savings account: $4,000
Result: $33,500 in pocket + $4,000 in savings account (net $37,500)

SAVING IN A PRETAX ACCOUNT
Pretax contribution to retirement account: $4,000
Taxable Income: $46,000
Tax Rate: 25%
Tax: $11,500
After Tax Income: $34,500
Result: $34,500 in pocket + $4,000 in retirement account (net $38,500)

Yes, that’s right, you’ve got $1,000 more in your pocket if you contribute $4,000 into a pre-tax plan. This example used $4,000, but you may be able to shelter considerably more per year or more if you are self-employed, have the required income level, and choose an appropriate plan. Now that you understand the benefit of tax-deferral, let’s move to an overview of the various plans.

Plans may be individual or employer-sponsored. First we’ll look at individual plans: the IRA and Roth IRA (http://www.irs.gov/publications/p590/index.html).

The IRA (Individual Retirement Arrangement) allows you to save while your investments grow tax-deferred until you withdraw them. If you’re eligible and under age 70 1⁄2, you can take a current tax deduction for all or part of your contribution. A full deduction is available ($4,000, or if over age 50, $5,000) if you aren’t covered by an employer-sponsored retirement plan. If you’re covered by a plan, you can still take a full deduction against your 2007 taxes if your AGI (adjusted gross income) is less than $52,000 in 2007 if you’re single, and less than $83,000 in 2007 if you’re married and filing jointly.

Also, if you’re married and filing jointly and either you or your spouse is covered by a retirement plan, the spouse who isn’t covered can make a fully deductible contribution as long as your combined AGI doesn’t exceed $156,000. The deduction is fully phased out at $166,000.

It’s a good choice if you qualify for a current tax deduction or you expect to be in a much lower tax bracket in “retirement.”

At the mention of the word “marriage,” I have to acknowledge the serious inequities regarding rights for same-sex partners. A 2004 General Accounting Office report found 1,138 benefits, rights, and protections provided on the basis of marital status in Federal law; gay and lesbian couples are excluded from all of these. Individual state laws afford a changing landscape of protections and benefits. Currently six states plus the District of Columbia now allow the registration of a domestic partnership. In the State of California, for example, new law requires RDPs (Registered Domestic Partners) to file a joint return using the married filing joint or married filing separate filing status. However, because Federal law does not allow RDPs to file a joint return, they must continue to file as unmarried individuals on their federal returns. Returning to the IRA…

You cannot take an early withdrawal without incurring taxes and a possible 10% federal tax penalty on some of your contributions and earnings unless a 72(t) exception applies. The 72(t) exception is for people who have a rare bone disease that results in a mouthful of multi-layered 72 tiny teeth instead the usual 32. A congressman’s daughter had the condition, so it became impacted into tax law.

OK, I made that up.  The real 72(t) explanation is at this link if you’ve really got to know:  http://tinyurl.com/2lbrq2    Good luck!

With the Roth IRA you pay income taxes up front and you never pay them on amounts withdrawn from the IRA again. Even though you can’t deduct contributions to a Roth IRA from your income taxes, it provides the most advantages for the most people, especially those with long time horizons. You’ll have more in the end than in a regular IRA, given enough time.

You can contribute the full amount ($4,000, or if over age 50, $5,000) to a Roth IRA as long as your MAGI doesn’t exceed these limits:
•    $99,000 if you’re single
•    $156,000 if you’re married and filing a joint return

The contribution amount is fully phased out at $114,000 if you’re single and $166,000 if you’re married and filing a joint return. You may be wondering what is a MAGI? It’s either the three wise men or modified adjusted gross income. Take your pick.

Contributions can be withdrawn tax-free and penalty-free at any time. The earnings on your contributions can be withdrawn tax-free and penalty-free if your initial contribution to the account was made at least five years ago and you’re age 59 1/2. You may be able to convert other account types, such as an IRA or 401(k), to a Roth IRA, subject to rules.

Employer-Sponsored Retirement Plans
(http://www.irs.gov/publications/p560/index.html)

If you are in business for yourself, regardless of your business entity type (such as a sole proprietorship, LLC, or S-Corp) you can utilize an employer-sponsored plan. Plus you can have both a regular or Roth IRA and an employer-sponsored plan.

The primary benefit to these plans is that contribution limits are higher than in a regular or Roth IRA. The possible drawback (or benefit, depending how you look at it) is that if you do have employees, you may be required to make contributions to their accounts as well. I’m going to describe only some of the most basic plans, their maximum contributions and under what conditions you would be required to cover any employees. There is both flexibility and complexity in designing how to implement these plans, and following is a summary description of the major plan types.

SEP IRA (Simplified Employee Pension)
•    Maximum Contribution: 25% of participant’s pay or $45,000, whichever is less.
•    Who MUST be covered: Any employee who has worked for three out of the past five years and is age 21 or older.
•    Cost: very little to set up ($10 for example); minimal ongoing paperwork and expense.
•    Deadline for setting up a SEP: You can set up a SEP as late as the due date (including extensions) of your income tax return for that year.

SIMPLE IRA (Savings Incentive Match Plan for Employees of Small Employers)
•    Maximum Contribution: $26,000.
•    Who MUST be covered: Any employee earning $5,000 during any two preceding years and who is expected to earn $5,000 in the current year.
•    Cost: very little ($10 for example); minimal paperwork and expense.
•    Deadline for setting up a SIMPLE: January 1 through October 1.

401(k) or Roth 401(k)
The plan design may allow for employee to choose to make their contributions with after-tax dollars, and would then be characterized as a Roth 401(k) plan.
•    Maximum Contribution: 25% of participant’s pay or $45,000 whichever is less.
•    Who MUST be covered: Any employee with 1,000 hours of service within one year and who is age 21 or older.
•    Cost: Trust and recordkeeping fees (can be several hundreds of dollars annually).
•    Deadline for setting up a 401(k): To take a deduction for contributions for a tax year, your plan must be set up by the last day of that year.

PROFIT-SHARING PLAN
You don’t need profits in order to make contributions to a profit-sharing plan. Contributions to a profit-sharing plan are discretionary.  There is no set amount that you need to make. If you establish a profit-sharing plan, you can have other retirement plans, such as a 401(k).
•    Maximum Contribution $45,000.
•    Who MUST be covered: Any employee with 1,000 hours of service within one year and who is age 21 or older.
•    Cost: Trust and recordkeeping fees (can be several hundreds of dollars annually).
•    Deadline for setting up Profit-Sharing Plan: same as 401(k).

DEFINED BENEFIT PLAN
The lure of these plans for sole proprietors is that older employee/owners can pack in significant benefits in a relatively short period. If you are an older artist whose career is coming along nicely but you haven’t yet accumulated assets for your next “re-engagement” period, you may want to take advantage. Notice the high contribution limit. However, once they are set up, these plans have mandatory contribution amounts. If your income is not fairly predictable, and you aren’t able to contribute the required amount each year, you will be disqualified and owe a significant excise tax. Like the profit-sharing plan, you can have other retirement plans at the same time.
•    Maximum Contribution $180,000.
•    Who MUST be covered: Any employee with 1,000 hours of service within one year and who is age 21 or older.
•    Cost:  Most expensive, with trust, recordkeeping and actuary fees. The complexity of these plans generally requires a few thousand dollars to set up and maintain.
•    Deadline for setting up DB plan: same as 401(k).

Taking Distributions from Plans
In all retirement plans except for the Roth types you’ll owe tax on withdrawals at your then-current tax rate. With certain exceptions, if you make withdrawals before age 59 1/2, you’ll owe a penalty of 10% plus whatever tax is owed. You must begin taking distributions when you are 70 1/2 (again, except for Roths).

Conclusion
From the shy, patient IRA to the glam-rock Defined Benefit plan, there’s a choice for almost every budget and dream. All that glitters is certainly not gold, but are those gold coins in the image below? Toss a coin of love into your own bucket and make a wish for peace and prosperity. Today is the hardest day to invest, but it’s the only day we’ve got.

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Michael Grodsky is a financial advisor (aquariusfinancial.com) who works with artists, collectors and business owners. Registered Representative offering securities and investment advisory services through Independent Financial Group, LLC, a registered broker-dealer, member FINRA, SIPC. This column is meant to provide general information, and should not be construed as providing individual financial advice. For investment, legal, and tax advice see your advisor, accountant, and attorney.

The S&P500 is an unmanaged but commonly used measure of common stock total return performance. It is composed of 500 widely held common stocks listed on the NYSE, AMEX and OTC markets. Investment return and principal value of stocks will fluctuate with changes in market conditions. It is not possible to invest directly in an index. Past performance is not indicative of future results. It is always possible to lose money when investing.

Image Credits

1. The Jabberwock. Illustration by John Tenniel (February 28, 1820 – February 25, 1914). Public Domain.
2. Golden Egg; Photograph 2006 courtesy of Nevit Dilmen; Permission is granted to copy, distribute and/or modify this document under the terms of the GNU Free Documentation License.
3. Two Supernumeray Teeth At Premaxilla. X-ray photograph courtesy of Albert. Public Domain.
4. Three Wise Men, named Balthasar, Melchior, and Gaspar. From a late 6th century mosaic at the Basilica of Sant’Apollinare Nuovo in Ravenna, Italy. Photograph 2006 courtesy of Nina Aldin Thune. Licensed under the Creative Commons Attribution ShareAlike 2.5 License.
5. Colorized transmission electron micrograph of Avian influenza A H5N1 viruses (seen in gold) grown in MDCK cells (seen in green). Photograph 1997 courtesy of Cynthia Goldsmith, Centers for Disease Control and Prevention. Public Domain.

© 2007 Michael Grodsky