My Favorite Way To Reduce Taxes (And How You Can Take Advantage)

If April 15th is a dreaded day for workers. Of course, it’s been a little different for the past couple of years, thanks to extensions from good old Uncle Sam. This year, instead of a global pandemic pushing back the deadline, it’s a holiday that we have to thank. This year, the deadline is Monday, April 18th.

Still, it’s no easier for retirees living on a fixed income. Uncle Sam can (and does) take a big bite out of millions of nest eggs each year. Those lost savings could mean fewer luxuries, such as winter cruises or trips to visit the grandkids. After seeing how fast taxes eroded their savings, some people have even been forced to rejoin the labor force.

Wouldn’t it be great if the taxman retired the same day you did? Imagine how much better retirement would be without sending Washington a check every time you withdrew money from your accounts. Well, thanks to the Taxpayer Relief Act of 1997, this dream is now a reality.

Specifically, I’m talking about the provision in this law that allows for the Roth IRA retirement account.

Many of you are likely familiar with the Roth IRA. But I’m willing to bet some of you haven’t taken advantage of this special tax-advantaged account before. Now may be the time to consider it. So let’s cover some of the basics today…

Roth IRAs: The Basics

1040 formA Roth IRA is similar to a traditional IRA or 401(K) in that it offers special tax perks. But while those plans allow for tax deductible contributions upfront, the Roth account gives you a tax break when you may need it the most… when you actually decide to spend your money.

That’s right. Any dividends, interest, and capital gains earned in this account are allowed to compound, grow, and eventually be withdrawn and used entirely tax free.

You don’t get to deduct contributions as they are made. But you get something much better in return… the freedom to pull out this money tax-free on the back end. That’s an incredible upgrade. Because every $1 you invest now could easily grow to $3 or more by the time you retire — quite possibly more for younger workers.

So instead of getting the tax break on the $1 now, you get it on the $3 later.

That’s a radical change from every other type of retirement account. But that’s not the only major difference. This unique plan is also more flexible with regard to investment choices. Sure, you can invest in stocks, bonds, and funds. But there are numerous other options. You can invest in real estate, race horses, private jets… even in bulls for cattle breeding. (You should still consult your tax professional, of course.)

But you don’t have to make such exotic bets to take full advantage of this incredible loophole. And all you need to qualify is “earned income” according to IRS guidelines.

There are contribution limits based on your household income and filing status. Most people can contribute up to $6,000 to a Roth IRA in 2021 and 2022 ($7,000 if you’re 50 and older), but I’ve included this table below for reference…

Why It Might Be Time To Open An IRA Right Now…

But the benefits don’t stop there.

— By putting your savings in this retirement account, you also rid yourself of the mandatory (and taxable) withdrawals from IRAs and 401(K)s that begin at age 70-and-a-half.

— With no forced withdrawals, your entire balance can grow without taxes for the rest of your life if you wish and pass on to your heirs. Since there is no income tax due, you can provide a child or grandchild with a lifetime stream of tax-free income.

— Since the income from this account isn’t taxable, it doesn’t count as income in figuring the tax on your social security payments. So if your only other source of income is Social Security, then you have a fully tax-free retirement.

— You can withdraw original contributions tax-free and penalty-free at any time for any reason, such as a down payment on a new home.

— You can keep putting earned income into this account even after you retire.

Establishing a Roth IRA is no harder than opening a checking account. Any broker or financial advisor will ask a few simple questions to make sure this account is right for you. All you have to do from there is sign a couple forms. If you prefer the do-it-yourself route, most any online broker has Roth IRA accounts available.

Even if you are above the income threshold, anyone can transfer traditional IRA assets to a Roth IRA regardless of filing status. Be careful before making this decision, as it may not be appropriate for everyone. Converting from a traditional IRA to a Roth IRA will trigger a tax bill on the amount of the conversion. For that reason, it can be smart to convert after a big market drop (when your account balance is lower).

Generally speaking, Roth IRA conversions are most advisable for investors who don’t plan to withdraw assets for 10 years or more. They also make sense for investors who anticipate being in a higher tax bracket in the future than they are today.

Closing Thoughts

As I mentioned before, once the Roth IRA account is established, any money you contribute will grow tax-free. Assuming an 8% annual return, $60,000 deposited will grow to $129,535. That’s $69,000+ in earnings that you can withdraw without owing the government a dime.

And that assumes no additional contributions. But what if you continue depositing $200 from each monthly paycheck into your account? Well, then you would be looking at $165,792 after 10 years. Again, completely tax free. Now that’s what I call a good tradeoff.

The question, then, is where to invest that money once you’ve opened a Roth IRA. Well, you could always invest in a blue-chip dividend payer like Home Depot (NYSE: HD). Nothing wrong with that. With a 2.5% yield, a $20,000 stake would put $500 in your pocket each year. Plus, you’re likely to enjoy solid appreciation in the stock price over the long run.

But to really take full advantage, you need to elevate your income stream beyond the usual suspects. That’s why I carefully scour the world of high-yielding investments each month to find the absolute best picks for readers of my premium newsletter, High-Yield Investing.

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