Most people view taxes as unavoidable… They’re inevitable, like death, right?
That thinking leads many people to ignore the huge benefits gained from investing through tax-sheltered accounts. But in an effort to protect us from its own taxes, the government graciously allows individuals to invest through several tax-deferred accounts.
The main examples are an individual retirement account (“IRA”) and a 401(k). In the next two essays, I’ll explain how these accounts work… and how they can provide you with instant returns that will compound your wealth for many years to come.
[ad#Google Adsense 336×280-IA]Today, I’ll cover the huge benefits offered by opening an IRA…
An IRA lets you park your cash and compound your wealth tax-free.
You don’t have to pay taxes on capital gains, dividends, or interest income for any stocks, bonds, or funds you hold within an IRA.
(If nothing else, this makes for simple accounting come tax time.)
Even better, you make contributions to a traditional IRA with pre-tax dollars (up to a certain level of income).
For instance, say you make $100,000.
With a marginal tax rate of 25%, you would owe roughly $16,857 a year in taxes (depending on a lot of other assumptions). So you’ll take home $83,143. If both you and your spouse make the maximum annual IRA contributions of $5,500, you’ll adjust your taxable income to $89,000. Your tax bill will drop to $14,107. You end up taking home $74,892… but you also set aside $11,000.
Another way to look at it:
You get $11,000, but it only cost you $8,250. That’s an immediate 33% return on your investment, which you then compound for decades.
The only downside is that you can’t withdraw your money until you reach 59-and-a-half years of age. If you do withdraw before then, you have to pay the taxes due on it plus a 10% penalty.
After 59 and a half, your withdrawals are taxed as ordinary income. If you withdraw $50,000 a year, that will count toward your annual income. You’ll be taxed accordingly. And when you reach 70 and a half, you must start making the minimum required withdrawals.
In short, if you don’t have an IRA now… open one immediately!
Opening an IRA is as easy as opening any other brokerage account. You can do it with any brokerage. When registering, you simply select an IRA as the account type.
When you file your taxes at the end of the year, the forms include a line to enter any IRA contributions. It’s as simple as that. And it will save you tens of thousands of dollars over just a decade or two of retirement savings.
There’s another type of IRA called a “Roth IRA.” These accounts let you make after-tax contributions. Then when you withdraw the income in retirement, you don’t pay any taxes on them.
This account makes sense for people who believe that their tax rate is lower now than it will be when they retire. That’s the case for some, but not for most. There are also income limits to Roth IRAs. If you make more than $129,000 as a single person or $191,000 as a married couple, you can’t contribute to a Roth.
But as I mentioned, there’s also another tax-deferred account that you probably have access to – a 401(k).
In tomorrow’s essay, I’ll explain the ins and outs of 401(k)s… and how these accounts can help you earn an instant 50% return on your money, even before tax considerations.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig Jr.