To save on income taxes, maximise your IRA

Rezworth Burchenson, Guest Writer

As March 15 looms, self-employed professionals are busy engaging accountants to complete their tax returns to meet the statutory deadline. These accountants will undoub-tedly be combing through the various expenses of these professionals to maximise the tax allowance.

But please note before you file.

• In May 2008, the Income Tax Act was amended, allowing persons contributing to an Individual Retirement Account (IRA) - that is, individual retirement schemes or approved retirement schemes - to make a tax deductible contribution of 20 per cent of emoluments or earnings.
  
• Previously, the limit was $6,000 per annum.

See the table for the difference this can make for income-tax liability of self-employed persons and other professionals who are not a member of a company pension plan.

The table quantifies the tax benefits 'earned and allowed' when the taxpayer makes a contribution to an IRA. Person A is not a member of an IRA and accordingly, pays maximum income tax on his assumed salary of $5 million.

From his net income, he seeks to save 20 per cent, which amounts to $750,000. However, if invested at a rate of 15 per cent outside of an IRA, he will be liable to withholding tax - applicable on most investment instruments - resulting in an overall benefit, that is, salary, savings and net investment income, of $3.8 million.

Person B, however, seeks to maximise his pension contribution at 20 per cent of salary, which reduces his taxable salary to $4 million.

However, his pension contribution when invested in an IRA is not liable to withholding taxes, resulting in a net benefit, that is, salary, IRA contributions and investment gains, of $4.15 million.

As the table above highlights, Person B, the IRA contributor, earned a superior benefit of $315,000 as compared to Person A.

IRAs also carry other benefits, for example, investment gains and investment income accrue and compound tax free over the saver's working life to retirement date; and the product is portable, which allows members to change managers, if investment performance is lacking.

Rezworth Burchenson is managing director of Prime Asset Management Limited. Email: rburchenson@primepensions.com.