George Graziano, CPA/ABV

Most people know they have until April 15, prior year contributions to their IRAs or self-employed retirement plans, and even longer for certain business retirement plans. But as a CPA specializing in tax matters I’m often asked, “When’s the best time to make contributions for this current year?” The answer, now more than ever, is NOW. Taxpayers are eligible to make current year contributions as early as January 1st of the current year. By doing so, they can begin the accumulation of tax deferred (tax-free in the case of Roth-IRAs) growth and earnings much earlier.

This one change in the timing of when contributions are made can create significant benefits upon retirement. As an example: a 40 year-old person establishes an IRA and will contribute $2,000 a year for 10 years; a total contribution of $20,000. Under Scenario 1, the annual contribution is made each January 1 of the current year. In Scenario 2, each contribution is made on April 15 of the following year. Assuming an 8% annual return, Scenario 1 will generate $10,000 more upon retirement at age 65 than would Scenario 2. That’s a $10,000 increase on a total investment of only $20,000 – that’s real money. All generated by simply accelerating the date that the contribution is made.

Why is now better than ever when it comes to accelerating the timing of retirement contributions? The 2001 Tax Act signed by President Bush contains numerous changes increasing the incentives for people to save for their retirement. Almost all of these changes became effective January 1, 2002. The more significant of these changes will increase the amounts that people can contribute annually to their retirement accounts now and in the future, sometimes dramatically. Increased contribution levels in turn increase the benefits that can be won by contributing early. NOW is the best time, especially for older Americans.

Some highlights of the increased contribution levels:

“Catch-up Contributions” for individuals age 50 and older. For most of the increases discussed below, the increase is even greater ($500 to $1,000 more annually, at a minimum) for those that have attained age 50 by the end of each year of contribution. In some cases, the catch-up contribution is significantly higher than the regular contribution.

IRAs – Traditional and Roth
Under prior law, $2,000 was the maximum annual contribution, which had been the case for many years. For 2002, the new limit is $3,000 (the “catch-up” limit is $3,500). These limits will further increase at periodic intervals through 2008 when the limit will stand at $5,000 annually ($6,000 for “catch-up” contributions). Thereafter, the limits will be indexed for inflation.

Employee Deferrals into 401(k), 403(b) and 457 Plans
For 2000 and 2001 the maximum employee deferral was $10,500. For 2002, this amount rises to $11,000 and increases by $1,000 each year thereafter until topping-out at $15,000 in 2006. Catch-up deferrals rise to $12,000 in 2002, and increase by $2,000 annually until reaching their maximum of $20,000 in 2006. Beyond 2006, these amounts are indexed to inflation.

Employee Deferrals into SIMPLE Plans
In 2001 the maximum deferral was $6,500. This amount increases to $7,000 in 2002 and by $1,000 annually to $10,000 in 2005. Catch-up contributions start at $7,500 in 2002 and eventually achieve $12,500 in 2006. Thereafter, these amounts are indexed to inflation.

Defined Contribution Plans
For 2001, the contribution limit for each plan participant is the lesser of 25% of compensation or $35,000. For 2002, this limit has been increased to the lesser of 100% of compensation or $40,000. The maximum amount of eligible compensation that can be considered when determining contributions has also been increased to $200,000 from $170,000 in 2001. These limits had already been indexed for inflation under prior law, but now, the manner in which they are indexed has been liberalized allowing for more frequent increases in both the contribution and compensation limits.

Defined Benefit Plans
The maximum annual benefit payable out of a defined benefit plan has been increased to $160,000 from $140,000. This higher limit is reduced for retirements beginning before age 62 and increased for retirements beginning after age 65.
Other Significant Changes to Retirement Accounts

• Liberalized rules regarding the ability of owner-employees to borrow from their own plan accounts.
• Increased limits and liberalized rules for determining the maximum tax deduction allowed to employers who make retirement plan contributions.
• From 2002 through 2006, certain low and middle-income individuals will receive a tax-credit of up to 50% of retirement account contributions they make. This credit is non-refundable, but is in addition to any deduction or exclusion from income the taxpayer may already be benefiting from. For a married couple filing jointly, the credit is 50% of the contribution for Adjusted Gross Income (AGI) between $0 and $30,000. The credit rate is reduced to 20% for the next $2,500 of income, and then to 10% for AGI between $32,500 and $50,000. For AGI over $50,000 the credit disappears.
• Beginning in 2005, the ability for 401(k) and 403(b) plans to allow employees to designate their deferrals to be treated like Roth-IRA contributions – tax free upon withdrawal, but not excluded from income upon contribution.
• Beginning in 2003, certain plans can allow employees to make traditional or Roth IRA type contributions to the plan.
• Liberalized rules governing roll-overs from one plan to another.
• A tax-credit available to certain small businesses establishing a new retirement plan of up to $500 a year for three years.
• Liberalization of the so-called “top-heavy” rules.

All of these changes provide significant tax incentives for individuals and employers to secure more funds for retirement savings. The time to act is now. However, one of the frequent stumbling blocks preventing people and especially employers (whose contributions can be relatively large) from making contributions early in the year is cash-flow. Contributing the money early removes it from the ability to use it later in the year if the need arises. If this obstacle exists for you, I believe it can be overcome if the contributions are budgeted and paid as periodic payments throughout the year. Contributing relatively small amounts throughout the year can ease cash-flow concerns and will still add up to big dollars come retirement time.

When it comes to building a nest-egg, a very wise person once said: “Pay yourself first”. I believe this is especially true when coupled with the benefits of tax-deferred or tax-free savings.

Directly related to this issue is the age at which one should start saving for retirement. Again, the answer is as simple as this, regardless of your current age…..NOW. I’ll illustrate this with one suggestion. If you have teenage children, or grandchildren who are working and earning wages, either in the family business or some other enterprise, seriously consider making them a gift of an IRA contribution. IRA contributions can be matched with wages dollar-for-dollar up to the maximum contribution amount. Meaning that someone with $3,000 in wages in 2002 can make a $3,000 IRA contribution for that year. This can be a traditional IRA or a Roth IRA. If traditional, the child will get the deduction. An even better suggestion, if you’re pretty sure the kid will earn $3,000 this year – make the contribution now. Someday, the child will be eternally grateful to you for securing his or her future. Number–crunching bears out that an individual who makes consistent retirement contributions early in life will almost always wind up with a larger sum upon retirement than someone who started later in life, even if the early starter stops making contributions after a relatively short period, and the late starter eventually contributes a much larger sum in total.

Caveat #1 regarding California tax law. California has yet to pass legislation that would conform state law for many of the retirement changes to the new Federal law. It is hoped that they will do so, but nothing has happened as of yet.

Caveat #2 regarding the Federal 2001 Tax Act. Due to Federal budgetary constraints, the entire Act and all – all – of its provisions are set to sunset, or disappear, effective January 1, 2011, and the entire Tax Code on that date will resort to how it existed as of January 1, 2001. Now, I have not heard anyone who believes that Congress would actually allow this happen, but that does mean that between now and then, new tax legislation will almost certainly change the rules again.

For my money, that means start gittin’ while the gittin’s pretty good.

This article is intended to provide generally information only, and does not represent any specific tax advice regarding any individual or company’s unique tax situation. In no way does this article represent financial advice. For assistance in your own situation, please seek the counsel of your tax and/or financial advisor.

George Graziano, CPA/ABV is the tax manager for the Grass Valley Public Accounting and Business Consulting firm of Francis, Scinto + Graziano, LLP. He can be reached at 273-3200 or george@fsa-cpa.com