I?m not a big fan of rules of thumb in the realm of personal finance, primarily because we are such inherently varied and volatile beings that most scenarios end up being the exception?not the rule.? But at risk of breaking my personal rule not to impose them, you will find five tax-driven directives that I am able to endorse but for a few anomalous circumstances.
In my previous post, I called upon the mantra ?Don?t let the tax tail wag the dog!? and addressed ?5 Tax Myths? that many mistake as rules and asked you to consider renouncing them.? Following are ?5 Tax Rules? you should be able to employ to good effect:
Rule #1: Take Advantage of a 401k or Other Retirement Plan
The most effective way for most people to minimize taxes is through the use of a retirement plan, such as a 401k, 403b, or simple IRA.? These are corporate retirement plans that allow you to make pretax contributions to an account that will grow tax deferred until you take distributions in retirement.? In 2012, an individual can contribute $17,000 to a 401k; if age 50 or over, an additional $5,500 catch-up contribution is allowed.? If you make $66,000 per year and contribute $16,000 to your 401k, your taxable income is reduced to $50,000, and you keep the investment.? After you have parted service from a company and reached age 55, distributions can be taken from a 401k without penalty, but the distribution will be treated as taxable income in the year in which it was taken.
Rule #2: Take Advantage of a Roth IRA
A Traditional IRA functions similarly to a 401k or other corporate retirement plan.? Contributions up to $5,000 ($6,000 if age 50 or older), for those with income under $56,000 for a single individual or $90,000 for a married couple, are deductible and thereby reduce taxable income.? As in a 401k, the growth in a traditional IRA will also be tax deferred, but distributions?in this case, after age 59??are subject to full taxation.? .
A Roth IRA, however, is a different animal.? With a Roth, you do not receive a tax deduction on the front end, but the money grows and is distributed tax free.? You don?t need to get your eyes checked; I did say tax free, and those opportunities are few.? The limitations are that you may only contribute $5,000?if 50 or over, $6,000?and make less than $110,000 for an individual or $173,000 as a married couple to be able to contribute the full amount[i] in 2012.
The argument historically has been that if you are young and in a low tax bracket, you should contribute to a Roth; if you?re older and in a high tax bracket, contribute to a traditional IRA because by the time you take distributions from your Roth IRA, your bracket will likely be lower.? But, I suggest that anyone who is eligible to contribute to a Roth should do so.? The reason I can be so broad is that almost all of us will have the bulk of our retirement savings in vehicles like a 401k?all of which will be taxed upon distribution.? In retirement, if we need income, we?ll be forced to take it from our 401k or Traditional IRA ?buckets? and thereby forced to pay tax on it.
It is beneficial for anyone planning for retirement or financial independence to have at least one bucket from which they can take distributions without paying any tax.
Rule #3: Create a Liquid Investment Account?? ?
A liquid investment account is just a standard individual or joint investment account in which you pay typical taxes.? In this account, if you own income-producing bonds, you?ll pay ordinary income tax? on the interest in the year in which it?s received.? If you own stocks, you don?t pay any taxes on the growth until you sell the stocks, and when you do, you?ll pay capital gains tax on the gain (on any stock held over one year), which is currently 15 percent (with very few exceptions).? If you lose money on stocks, when you sell them you can take a tax loss.? When you prepare your taxes, tax losses can be offset against gains, neutralizing the taxable event.? Dividends from stocks are taxed in the year in which they are received at the dividend rate, which is also currently 15 percent?but possibly not for long.? Mutual funds, which own stocks and bonds inside of them, pass the taxable impact of capital gains and income on to the mutual fund shareholders.
With all this taxation to manage, why would I suggest you maintain a liquid investment account as a tax strategy?? If a portion of your portfolio is focused on investing in stocks, long-term capital gains taxation is preferable to ordinary income tax treatment.? If you invest in a stock in your IRA, it will grow tax deferred, and if you sell it in the future and take a distribution from the IRA, you?ll pay ordinary income tax rates, the highest of which is 35 percent in 2012.
If you bought the same stock in a taxable, liquid investment account, your gains would be deferred until you sell the stock in the future.? When you sell the stock years later, you will hopefully have a capital gain and, based on today?s rate, you?d pay 15 percent on the gain.? If you are in a high tax bracket, the difference between that 35 percent tax in the IRA and 15 percent tax in the liquid investment account is significant.
Rule #4: Do Long-Term Investing for College in a 529 Plan
The 529 college savings plans offer a tax-privileged way to save for college, but this rule comes with a caveat.? From a tax perspective, the 529 functions much like a Roth IRA.? Dollars invested in the plan receive no special federal tax treatment initially (although many states offer a state tax deduction for some contributions), but they grow tax deferred and are distributed?if used for qualifying education expenses?tax free.? The caveat is that one?s time horizon must be fairly long to withstand the volatility of the investment vehicles likely to net a meaningful gain.? My next post will discuss in greater detail the benefits and drawbacks of 529 education plans, but I?ll give you a quick preview: you shouldn?t put ALL of your college savings in 529s, but it?s often wise to utilize them for 50% of your education savings.
Rule #5: Utilize a Health Savings Account
If Health Savings Accounts would?ve been available, understood and adopted much earlier, I honestly believe they could?ve reformed our healthcare payment system without need for actual reform, but I must also mention them for their tax benefit, because the HSA may be the multiuse investment vehicle with the most tax privilege allowed by the IRS.? Whether you?re talking about a 401k, a traditional IRA, or a Roth IRA, the IRS only allows you to get a tax break on one side of the timeline?either your contribution or your distribution is tax privileged, but not both.? The HSA, however, allows both the front and the back end tax break.? Every dollar contributed to an HSA is a deduction.? If your employer contributes, they get the deduction; if you contribute, you get it.? The money grows tax deferred, and if you take a distribution to pay for qualified health expenses, the distribution is tax free!? That?s the best deal on the street.
I?ve created an exercise designed to help you recognize the 5 Tax Myths and ensure you?re taking advantage of the 5 Tax Rules.? Click HERE to find instructions and the free download.
Much of the material in this post was legally stolen from the book I co-authored with best-selling author, Jim Stovall, called The Ultimate Financial Plan: Balancing Money and Life, in which you?ll find more on this particular subject in Chapter Eleven: The Gift of Preparation.
As mentioned, if your income falls below $110,000 (single) or $173,000 (married filing jointly), you may contribute the full $5,000 per person, but there is also a ?phase-out? rule that applies.? So, if you?re single, you may be able to make a partial contribution to a Roth IRA if your AGI is between $110,000 and $125,000 on a proportionate basis.? If your income exceeds $125,000, congratulations?you can?t make a Roth contribution.? For those married filing jointly, the phase out is between $173,000 and $183,000.? As if it wasn?t confusing enough?
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