Spending Wisely

Stick It to the Taxman

2020 may already be over, but you still have a simple way to stick it to the taxman...

This strategy is one of the most powerful ways to shelter your wealth from the IRS... grow money for retirement... and have freedom in your investment choices.

It's a type of brokerage account called an individual retirement account ("IRA").

With this type of tax-deferred account, 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 it.

Being able to let your wealth compound without the drag that taxes cause can give you hundreds of thousands of dollars more in retirement.

If you don't already have an IRA... or you haven't fully funded yours yet... don't worry... you still have time to contribute for 2020.

Think of it like opening any checking or savings account at your local bank. And to help you out, I'd like to go over some basics of IRAs in this issue of Health & Wealth Bulletin...

Who Can Open One?

Anyone who has earned income in the current year can open an IRA. You must have taxable income to be eligible.

IRAs are for individuals... Spouses can't be co-owners. If you file taxes jointly, each spouse can open an IRA even if only one earns income.

How Much Can You Put In?

The maximum contribution to an IRA is $6,000 annually for an individual.

If you're 50 and older, you can contribute an extra $1,000 for a total of $7,000 annually (or $14,000 for a couple 50 and older using two IRAs). That extra benefit is so you can "catch up" in your final retirement-savings years.

How Long Do You Have?

A common misconception is that you have to contribute for a particular year during that year.

But you actually have until the due date for filing your tax returns to make a deposit to the previous year's IRA. That means that this year, you have until Thursday, April 15, 2021, to make an IRA contribution for 2020.

If you're contributing to the "prior" year, make sure to tell your plan sponsor (your broker or bank) that you want it to count for the prior year.

Now, everything that we've talked about so far applies to all IRAs... But there are two different types of accounts: a traditional IRA and a Roth IRA.

What's the Difference?

When you contribute to a traditional IRA, you're contributing with pre-tax dollars. Your contributions to a traditional IRA can help lower your tax bill. And a traditional IRA doesn't have limitations based on income.

Sometimes when you prepare your taxes, you'll find you owe a small amount. You can often lower – or even eliminate – that tax liability by making an IRA contribution since you can make it count for the previous year. You'll pay more into the IRA than you will on the tax bill, but at least you'll be keeping the money for yourself instead of giving it to the taxman.

A traditional IRA also lets you compound your wealth from investments tax-free. You don't pay taxes on capital gains, dividends, or interest payments until you start withdrawing from your IRA.

After reaching age 59 and a half, you can make withdrawals that the IRS taxes as ordinary income. For example, if you withdraw $50,000 a year, that will count toward your annual income. The IRS will tax you accordingly.

And when you reach 72, you must start making withdrawals known as "minimum required distributions."

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, plus a 10% penalty (with some exceptions).

A Roth IRA is sort of a flipped version of the traditional IRA. While you don't get a tax break on your income when you contribute, you also don't have to pay taxes when you make withdrawals.

Thanks to the SECURE Act, which went into effect January 1, 2020, you can contribute to a traditional IRA or a Roth IRA at any age. But with a Roth IRA, you don't have to take any minimum-required distributions. But there are income restrictions...

Individuals making more than $139,000 in 2020 aren't eligible to contribute to a Roth IRA. A married person filing jointly can't contribute if his or her household income is more than $206,000 in 2020. (If you make slightly below these limits, you may be able to contribute a reduced amount.)

How Do You Know Which One to Open?

A traditional IRA most benefits people who expect to be in a lower tax bracket when they retire than when they are working.

A Roth IRA best works for people in the opposite situation. If you expect that your taxes will be higher as a retiree than as a working person, a Roth is perfect for you.

We often recommend opening both a traditional and a Roth IRA if you are unsure what your tax situation will be in your retirement. That way, you get the benefits of both methods.

Alternatively, a more advanced strategy is to convert a traditional IRA to a Roth. You won't need to pay income taxes on subsequent withdrawals, but you will need to pay a lump-sum tax when you do the conversion. This can get tricky, so we recommend talking with your financial planner about your options.

Where Should You Open an IRA Today?

Opening an IRA is as easy as opening any other brokerage account. You can do it with any broker. I like TD Ameritrade and Fidelity, but I've also heard good things about Interactive Brokers. Of course, we don't have any financial relationship with any broker – we work for you.

When registering, you simply select an IRA as the account type.

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.

What We're Interneting...

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig and the Health & Wealth Bulletin Research Team

February 18, 2021