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Uncle Sam Offers a Hand

Published: Saturday, 07 January 2012

In the last issue, ficticious client Wendy Wise increased her tax deferred retirement contributions to close the gap in her retirement savings rate. Had she not done this, she would have been forced to work into her late 70’s to maintain her current living standard. This act has the double benefit of lowering her tax liability, and cracking the door open to more tax perks - available to lower income earners. If Wendy had not begun tax planning now, her lifetime state and federal income tax burden would likely have been a 7 digit figure. Although we couldn’t do anything to change her past tax liabilities, we can make immediate further changes to substantially reduce her current taxes and boost her current spending power.

Drilling For Dollars:

A further review of Wendy’s financial plan revealed a need to diversify her investments and increase her current investment income at least tenfold without increasing her taxes. Wendy said she could also use an immediate tax reduction for 2011 to extend over several years to offset planned raises she anticipated for her highest earning years. In short, we want to give her a big raise in income and give her a big lasting tax cut too. How could this be? It doesn’t make sense that income can increase and taxes immediately decrease. A review of section 63c of the Internal Revenue Code, IRC, revealed that Wendy qualifies for a tax-favored investment in an independent drilling contract, IDC, for oil and gas wells. This investment is projected to provide a much needed monthly income stream well into her retirement years when her Social Security can kick in to close her income gap as this investment income gradually declines due to more and more wells drying out with time. In December 2011 Wendy purchased a general partnership interest in US Energy, an oil and gas development company. Her first year, 2011, is considered a total loss because all of her investment was at risk and she had no investment income from her IDC. Instead of taking her entire investment as a loss in 2011, she elected to spread her losses over 5 years as permitted in IRC section 63c. This removed $10,000 from her taxes in 2011. Although she isn’t likely to see any income until after her first year when her first wells are drilled and producing, her current tax benefits more than offset her first year investment income dry spell.

Uncle Sam Lends Another Hand:

Wendy was Jubilant to see her income taxes cut by more than half. “Wait, we’re not done yet.” I said. I advised her to make the election on her 2011 federal income tax filing for a tax savers credit. I explained that this is a 50% credit in addition to the tax deductions she is already getting for contributions to her 401k plan and her Traditional IRA. I further explained that since this credit applies equally to a Roth IRA. Although she had until April she agreed to open a Roth IRA immediately and fund it with $100. How will the credit affect her taxes?

Taking Her Credit:

The Savers Credit is equal to a percentage of either employee contributions to an employer-sponsored retirement plan, or individual or spousal contributions to an individual retirement arrangement (IRA). The maximum annual contribution eligible for the credit is $2,000 each for taxpayer and spouse. This credit is available in addition to the tax deduction you are allowed for IRA and Employer contributions to her retirement plan. Most importantly, it is a dollar for dollar reduction in her tax liability. In effect, Uncle Sam will pay her for contributing to her Roth IRA! When Wendy files her taxes in a few weeks we’ll compare her 2011 return against her prior year to review her actual savings and look at her increased purchasing power, aka, after tax cash flows. They’ll be more on that in the next issue.

The Power of Planning:

In just a few sessions, Wendy has seen her cash flows and credit scores increase dramatically. Although not there just yet, she is well on her way to a great life today and a prosperous retirement. Thank you Uncle Sam!