At the end of the day is not how much money we make that matters. It’s how much of it we get to keep.
With the tax deadline around the corner, I hereby encourage individual investors to take advantage of every ethical and commonsensical opportunity to reduce their tax bill and set some of their investable dollars into tax-free and/or tax-deferred gear. In the following couple of paragraphs I briefly explain the possibilities and structure of tax-advantaged investing in the United States. So read on and find out how you can make the most out of your of your money before you submit your 2014 tax report come April 15.
The U.S. tax code allows individuals to save and invest for retirement in tax-advantaged accounts. Any legally employed individual earning an income can opt to contribute to his employer-sponsored 401K plan as well as to Independent Retirement Accounts, which are also referred to as IRAs. To the former one can contribute up to $17,500 on a tax-deductible basis in any given fiscal year. As to the IRAs, the contribution limit is set at $5,500.
There are two types of IRAs. One is the Traditional IRA and the other is the Roth IRA. Contributions made to 401K plans and Traditional IRAs are tax-deductible in nature. This means that the amount of money contributed to these accounts are deducted from our gross income, which, in turn, reduces our tax bill, and, at the same time, potentially increases our disposable income.
As to the investments made through these two accounts, they grow on a tax-deferred basis. This means that the capital gains on the assets held in 401K and Traditional IRA accounts are not taxed year to year. Therefore, instead of giving a chunk of your yearly capital gains to the government, you get to keep it in your account for tax-deferred compounded growth. The withdrawals you will eventually make from these accounts during retirement will be taxed as earned income based on your tax bracket.
With respect to Roth IRAs, the yearly contributions are made on an after-tax (non-deductible) basis. So where’s the tax advantage here, one might ask. Firstly, the growth on the assets held in the Roth IRA account is non-taxable. Secondly, unlike Traditional IRAs, withdrawals from Roth IRAs during retirement are also non-taxable which makes the account totally tax-free.
Whereas everyone who earns income is eligible to make contributions to Traditional IRAs, in order to contribute towards a Roth IRA one must have a Modified Adjusted Gross Income (MAGI) of less than $129,000 if filing single or less than $191,000 if married filing jointly.
It is important to highlight the fact that these are retirement accounts and that early withdrawals are subject to penalties. A withdrawal is considered early if it is made before reaching the age of retirement, which is currently 59.5 years in the United States. An early distribution or withdrawal may be subject to an additional 10 percent tax on top of whichever income tax bracket applies to you at the moment the withdrawal is made. People frequently ask if an early distribution from a Roth IRA is also subject to penalties. The answer is yes, but since the contributions to the Roth account are after-tax, only the 10 percent penalty applies.
However, there are specific cases in which the 10 percent penalty is exempted altogether. Among these probable cases is the death or disablement of the account holder. Under such circumstances, the disabled person or surviving beneficiary would not have to pay the penalty for early withdrawal.
Finally, investors must realize that that every fiscal year they do not maximize their contributions to their tax-advantaged accounts is a veritable missed opportunity that can never be regained.
One could say, “Oh there’s always next year.” Maybe, but considering the time value of money, delaying our investment until next year can make a world of difference. Let’s say, for instance, that you’re currently 30 years old and could contribute $3,000 to your Traditional IRA account every fiscal year until you retire at age 60. Supposing that you receive a 7 percent average annual return on your investments, your total before taxes account balance thirty years from now would be $303,219.
If you miss this year and begin contributing next year at age 31 your total balance before taxes would be $280,382; a difference of $22,837 less than what you would have accumulated should you have begun contributing at age 30.
Bottom line: maximize your contributions to tax-advantaged accounts as much as you can today without delay. Make it a matter of priority and you’ll enjoy a superiority in returns unbeknownst to those that are lax and don’t mind being unnecessarily taxed.