The 1st quarter of the year following the holiday season is filled with a commonplace task for each of us: taxes. Big and scary, complex and misunderstood, many Americans find an aversion to doing their taxes for many reasons, simplicity being chief among them.
Is simplifying our “tax life” our best choice, or is there a golden opportunity here awaiting us? A proposition to you is that despite any related stressors of tax season, tax planning can be one of the greatest strategies you can implement as a tool in your wealth-building plan. It has the potential to propel you forward toward your financial future.
In the short term, there are many opportunities to reduce your taxable income today through specific actions you can take.
Many of us have heard the terms deductions, credit, marginal tax rate, etc. It does seem obvious that many Americans want to reduce their taxable income today. There are several ways to place money in tax-advantaged accounts to reduce your tax liability this year.
Several of these may be Flexible Spending Accounts, Health Savings Accounts, 401k, 457, 403b retirement plans, and Traditional IRA’s. Contributions to these accounts allow you an opportunity to save in a tax-advantaged account.
Secondly, they lower your taxable income today. In effect, your contributions to these accounts reduce your taxable income by the amount you are able and willing to contribute to the aforementioned accounts. The money in these accounts grows tax-deferred, or in other words, you will pay tax on the principal and any growth later.
This area of planning sounds amazing because, let’s be honest, no one really enjoys paying their tax bill. Paying less today sounds like a great option—and for many, it can be a great choice.
There is a trade-off in this area between reducing either your short-term tax liability or your long-term tax liability.
The idea of this trade-off is what we generally describe as an opportunity cost: taking one action negates your ability to exercise the other choice(s) you have. If you can afford it and are willing to sacrifice current-day reductions in tax liability, that benefit can essentially be postponed to a later date.
Here’s how it works: You will choose to use different retirement account options and features to create tax-free or “after-tax” money. With a Roth IRA, you choose to pay your taxes today on that money rather than receive a tax deduction today. This money and growth through dividends and interest are tax-free. You never pay another dime of taxes on any money put inside of any “Roth” account.
Many 401k options today have already developed a Roth option. You can elect to contribute to your 401k, but have it placed into a Roth portion of your 401k where the principal and any growth is tax-free after age 59 ½. This only applies to YOUR portion of contributions; employer funds currently are always taxed as traditional 401k contributions or in a tax-deferred manner.
Although Roth IRA’s and Roth 401k’s require an outlook that is much more long-term in nature, if done properly, it has the potential to save you on taxes overall. You will pay more out of pocket today, but down the road, you could really be patting yourself on the back for taking the Longview. Getting “tax-free” income during your retirement allows you more flexibility and an opportunity to minimize your taxes in retirement.
To give you a base to start from, let’s say that a couple aged 30 with $50,000 in Roth IRAs wants to project the values of their IRAs by retirement time. We will consistently assume that they receive a reasonably modest, realistic, and safe rate of return of 7 percent.
We will assume that they are able to save $10,000 towards retirement every year until age 59 ½, when they can begin to withdraw money from their IRAs. The projected future value of their retirement accounts at age 59 ½ equals $1,229,178.15.
Yes, this is yours to spend, but let’s look at an alternative. Let’s presume you have also saved well in some tax-deferred accounts simultaneous to your Roth retirement accounts. If you choose to spend those to 0 in retirement, you have a huge opportunity to give a lot of money to your heirs. Simply leaving the Roth IRA’s alone until age 78, they should have grown to be $4,819,146.26 in value.
$4,819,146.26 completely tax-free to your heirs. What an accomplishment, and this could be you.
Here at TrueNorth Wealth, wealth planning is exactly what we do. Our expert financial planning team is here to assist you along the path to your financial future and guide you every step of the way. If you’re looking for asset management in Salt Lake City or a social security advisor to help plan for your retirement, contact us today!