How to protect your income from the I.R.S.

After seven years at Howard University, including four at the medical school, and a four-year residency at King Drew Medical Center in Compton, California, Dr. Adrienne Alston bought an ophthalmology practice in Harbor City, California. This shining moment,however,was about to be eclipsed by Uncle Sam and the Internal Revenue Service. Alston suddenly herself making over six figures and in the top tax bracket, which meant a combined 45.4% federal and state tax bite.

Thanks to new laws, Alston's deduction options were whittling away, so she began seeking advice on tax-advantaged saving vehicles. That was 11 years ago. Today, the 41-year-old has saved more than $150,000 through tax-deferred investing. She stashes away about 20% of her pre-tax income, mainly through a Keogh for herself and her five-member staff.

Like Alston, millions of Americans seek ways to stash money in tax-deferred vehicles such as 401(k)s, individual retirement accounts (IRAs) and annuities, or tax-free instruments, such as muni bonds and Treasury securities. And with good reason: income taxes can chomp away at a third of your investment income.

By reducing your tax bite, you could save 15-40 cents on every dollar you earn, depending on the tax bracket you're in. That's not including money you could save on your state income taxes. Moreover, Investing in tax-free and tax-deferred vehicles increases the value of your money over time-funds that otherwise would have gone to Uncle Sam.

"Today's environment underscores the increased importance of tax exemption," says Pierre Dunagan, associate vice president of investments at Dean Witter Reynolds in Matteson, Illinois. "Federal, state and local taxes are on the rise," he adds, pointing out that the top personal tax bracket has been raised within the last 18 months in several states.

There are key distinctions between tax-free and tax-deferred investing. Tax-free, or tax-exempt, investing means exactly that: no tax due now or in the future. On the other hand, tax-deferred investing means that no taxes are due now but will be due in the future when your money is withdrawn or assets sold. Qualified retirement plans, IRAs, investments within life insurance policies, Series EE bonds, deferred compensation plans and annuities are all tax-deferred.

The benefit of deferral is the fact that no taxes are paid until your money is withdrawn, usually at retirement age, at which time you'll likely be in a lower tax bracket. Until then, your earnings are reinvested and compounded with nary a penny to pay in taxes along the way.

Whether you're in your 20s or 40s, just starting to work or close to retirement, you'll find that tax-deferral offers significant benefits. Still, figuring out the best investments is not easy. Here are some helpful hints from the experts.

THE 411 ON 401(k)s AND IRAs

Those in the 28% or above tax bracket, who have 20 or more years before reaching retirement age, should invest in their company's 401(k) plan. This defined contribution plan is an ideal way to stash away some of your pre-tax income. You can elect to take a salary reduction or forgo a salary increase and instead have the money placed in the 401 (k) plan. You can contribute up to 25% of your earned income or the maximum dollar amount allowed per year ($9,500 in 1996). All earnings in the plan are tax-deferred.

"Maxing out," that is making the, maximum contribution allowed, should be your investment mantra, says Carol Ward, a budget analyst at Brandeis University in Waltham, Massachusetts. With no dependents or property to claim as deductions, Ward, 32, found herself under a huge tax burden. But she now defers 15% of her pre-tax income by maxing out on her 401(k) and contributing to an IRA.

If you aren't able to make the maximum contribution allowed, then start out small but incrementally increase your allocation at least 1%-2% every year, suggests Anita Robertson D'Aguilar, a financial consultant with Merrill Lynch in Century City, California.

Wart started with a 50% contribution last year, and recently boosted her allocation by 10%, thanks to a recent promotion and salary increase. Her money is invested in four different growth and balanced mutual funds.

To make the most of your 401(k), you need to understand the investment menus offered by your company. Know the objectives and performance of the funds and review your options yearly, advises D'Aguilar.

You'll be offered several investment options, including at least four mutual fund categories. Some funds will be better suited for producing income, others for maximizing capital growth. If you want to grow your assets, don't pick conservative or fixed-income investments. If your 401(k) plan has a company match, there's greater potential for compounding your investment.

You should take a look at specific options within your retirement plan, and if they're not adequate or if you don't have access to a company plan, then consider an IRA, suggests Bird Patrick, president of Security General, a financial planning firm in Boston.

IRAs were enacted by Congress as a way to encourage people to save and invest for retirement. Anyone who contributes to one receives a tax deferral, and most people get a tax deduction as well. With an IRA, your taxable income is reduced. If you're in, say, the 28% tax bracket, a $2,000 IRA contribution reduces your taxes by $560.

IRAs are inexpensive and widely available from banks and mutual fund companies. Plus, with IRAs you can create your own basket of investments.

If you have 20 years till retirement, Patrick recommends a mix that's 55% growth stocks or mutual funds, 45% balanced investments and 5% fixed income.

There are some limitations to IRAs. You can contribute annually up to $2,000 (or $4,000 for you and your spouse). Your IRA contributions are partially deductible if you're single and earn up to $35,000 annually, or if you're married and your combined income is $50,000 or less.

Kim Dulaney, a certified financial planner at Rinehart $ Associates in Charlotte, North Carolina, also points to Simplified Employee Plans (SEPs) and Keoghs for the self-employed. You can put up to 20% of your income, or $30,000 a year, in a tax-deductible Keogh, or up to I 13% of your income in a SEP, which is similar to an IRA. (See "Financial Savvy for the Self-Employed," September 1996.)

MUNI BONDS AND UITs

If you're concerned about the double whammy of federal and state taxes, you should consider municipal bonds (munis) or unit investment trusts (UITs), especially those issued by your home state.

Muni bonds are debt obligations Issued by city, state or local government agencies. Interest paid on municipal bonds is tax-free at the federal level. If you reside in the state or locality issuing the bond, then It's also free from state and local taxes. However, interest on Treasury securities is tax-free at both the state and local levels. Depending on your age and salary, muni bonds may not be for you. "Unless you are in the 31% tax bracket, munis really don't pay," says Patrick.

Let's assume you're in the 15% tax bracket and trying to decide between a tax-free municipal bond paying 5% and a Treasury bond paying 7%. Which deal is better?

In this case, the effective tax-free yield of the municipal bond equals 5.9%. Here the 5% municipal bond is not nearly as attractive as the taxable Treasury bond yielding 7%. But it's a different story when your tax bracket is 31%. Now, the effective tax-free yield is 7.2%. Also remember that the yield spread between taxable bonds and tax-free bonds widens and narrows as market conditions change.

When shopping for munis, "look for triple A-rated bonds, which means the issuer has insurance coverage on the bond or a pool of assets to ensure payment in case of default," advises D'Aguilar. Check with rating services like Standard & Poor's.

Remember that the income on a bond is fixed, so you may lose money if your investment doesn't keep up with inflation.

Selling a muni before maturity when rates are rising subjects you to risks as well. To guard against these ups and downs, D'Aguilar suggests that you buy into a muni bond fund or UIT, both of which cushion your investment with a diversified portfolio.

A muni fund is basically a mutual fund that invests solely in municipal bonds. A UIT differs from a bond fund in that it's not actively managed. Unit trusts issue a predetermined number of shares or units; the fixed portfolio of securities in a tax-free UIT are selected to achieve specific investment objectives, usually monthly income and preservation of capital.

The initial investment on a muni fund or UIT can be as low as $1,000, and your income is still tax-exempt. Tax-free UITs may be insured or uninsured, and the securities in their portfolios may be chosen to satisfy specific state laws.

VARIABLE ANNUITIES 

Variable annuities are most beneficial if you're about 50 years old and have 15 years till retirement, and are in the 31% tax bracket, says Patrick. Since the money is locked in for a fixed period of time, often seven years, this isn't the best tool for younger investors who need more flexibility, he explains.

Annuities, provided by insurance companies, are marketed and sold through brokerage firms, banks and other financial institutions. Minimum investment requirements are generally $1,000-$5,000 or a small monthly contribution of $100. Variable annuities invest in a mix of mutual funds, giving you a more balanced retirement fund.

Unlike fixed annuities, which guarantee a fixed rate of return, variable annuities are subject to market fluctuations. Expenses are higher than regular mutual funds because of the extra 1%-1.25% insurance charge. There's also a surrender charge - a fee for when you bail out - that may run as much as 8%. To make the most of this vehicle, look at the cost of insurance vs. the growth of the investments in the product.

IRAs 401(k)sd and annuities are meant to be sources of income for retirement. So, if you withdraw any of these funds before age 59 1/2 , can expect a tax penalty of 10%.

Notwithstanding, the best way to keep what you earn and make your money work for you is to invest it in tax-free or tax-deferred vehicles. If invested properly today's dollar could be worth thousands tomorrow.