How to Shelter Income from Taxes
Maximize contributions to your workplace retirement plan:
One easy way to set money aside on a tax-advantaged basis is to participate in your employer-sponsored retirement plan - usually a 401(k) or SIMPLE, or for government and nonprofit employees a 403(b) or tax-sheltered annuity plan.
The IRS recently announced new and higher limits for 401(k) contributions for 2015. You can make elective deferrals of up to $18,000 per year, and another $6,000 on top of that if you are age 50 or older.
For 403(b)s, the elective deferral limit has also been raised to $18,000, with another $6,000 in catch-up contributions if you are age 50 or older.
The maximum contribution you can make to a SIMPLE plan via salary deferral is $12,500, with an additional $3,000 in catch-up contributions authorized for those aged 50 and older.
Your employer may provide a matching contribution. Speak with your HR staff at work or your supervisor for details about whether your employer matches contributions.
Self Employed? Own a Business? Start Your Own Retirement Plan!
You don't need to work for a large company to have a 401(k) plan. If you are self-employed or the owner/employee of a corporation, you may be able to start your own small-company 401(k) plan (often called a 'solo 401(k)' or individual 401(k) plan) to cover yourself and a spouse. You can shelter up to $18,000 in your own compensation from income taxes (up to $24,000 if you are age 50 or older). On top of that, you can have your company make contributions on your behalf - substantially increasing the amount of money you can set shelter from income taxes - up to $53,000 per year.
You may also consider a Simplified Employee Pension Plan (SEP) which has similarly high contribution limits. Simply establish an SEP account and you can contribute as much as 25 percent of your compensation up to $53,000 per year. There are no catch-up contribution provisions for SEPs.
You may qualify for a tax credit to offset startup costs in the first few years of establishing a plan. Contact your retirement planning or tax professional for details of the Small Business Retirement Plan tax credit.
Contribute to an IRA
Contributions you make to a traditional IRA are deductible up to $5,500, provided you fall under certain income limits. If your income exceeds these limits, you can still contribute up to $5,500, while taking a partial deduction, or simply contributing on a non-deductible basis. In either case, all assets in your traditional IRA will grow tax-deferred. You will only pay income taxes on amounts you withdraw. A 10 percent surcharge may apply to withdrawals made prior to age 59½, except for certain specified hardship conditions, or to pay for a college education for yourself or a loved one or to make a down payment on a home of up to $10,000. Required minimum distribution rules may apply after you turn 70½.
You don't have to itemize your expenses in order to take a deduction for IRA contributions.
If you are relatively young, or you believe your income tax rates in retirement will be higher than they are now, you may consider a Roth IRA. There is no tax deduction on contributions, but all assets that have been in the account for at least five years grow tax -free. That is, no income tax is due on withdrawals/distributions from Roth IRAs. A 10 percent excise tax may apply to withdrawals prior to age 59½, but only on the growth in the account - not on contributions returned to you, since you already paid income tax on those dollars.