Tax Magic: How To Turn Taxable Income Into Tax-Free Income
Posted by Nick Niesen on November 8th, 2010
Believe it or not, there are ways to convert taxable income into non-taxable income, without any fear of an IRS audit.
Here's one of my favorites. It's been part of our tax code for over 30 years, yet many still don't take advantage of it.
What am I talking about?
The IRA -- Individual Retirement Account.
Now, before you say, "Oh, I know all about that one; what's so great about an IRA?", give me 10 minutes to explain 3 new benefits to the IRA rules that you may not realize.
BENEFIT #1: How To Avoid Tax Rather Than Postpone Tax
First, did you know that there are now 2 kinds of IRA's available?
The so-called Traditional IRA is the one that first came out way back in the 1970's.
But there's a newer version of the IRA that's only a few years old -- it's called the Roth IRA. And the difference between these 2 IRA's is huge.
Traditional IRA contributions are tax-deductible, resulting in immediate tax savings. The growth of those contributions is also tax-sheltered while the funds remain in the account.
But eventually all tax-deductible Traditional IRA contributions, as well as the growth of those contributions, will be subject to income tax when the money is withdrawn from the account.
In other words, Traditional IRA's offer the opportunity to temporarily postpone taxes.
In contrast, the Roth IRA offers the opportunity to permanently avoid taxes. With a Roth IRA, you don't take a deduction for your contributions; instead, you make a contribution with "after-tax" dollars.
Whatever you put in not only grows tax-free, but can also be withdrawn tax-free.
Here's an example to illustrate:
If you invest $2,000 per year for 20 years into a Roth IRA, you will have invested a total of $40,000. Now if that Roth IRA earns an average of 10% per year, that $40,000 will grow into $126,005.
Now comes the fun part: Assuming the IRA has existed for at least 5 years and you are at least 59 ½ years old, you can withdraw the entire $126,005 tax free.
In contrast, if this money had been invested in a Traditional IRA, the entire $126,005 would be subject to income tax as it is withdrawn.
The $86,005 of growth is magically converted from taxable income to non-taxable income. Assuming you are in the 15% federal tax bracket, that's a savings of $12,901. Add any state income tax, and you could save over $15,000 in taxes.
BENEFIT #2: Take An Extra 3 ½ Months To Fund Your IRA
The deadline for contributing to your IRA is April 15 of the year AFTER the year for which the contribution made.
So for Year 2005, you have until April 15, 2006 to put money into your IRA.
If you've already invested the maximum (more about that in a moment) by December 31, 2005, then you're done. No more money can go into the IRA for 2005.
But if you haven't maxed out your IRA, you have until April 15 to do so.
Which brings me to . . .
BENEFIT #3: The Maximum Contribution Amounts Have Increased
For many years, the most you could put into an IRA was $2,000. Now, the maximum is $4,000 (assuming you have at least that much earned income from wages or self-employment income).
And if you are over 49, you can put in another $500, bringing the total maximum to $4,500.
A married couple, both age 50 or older, can put a whopping $9,000 per year into a IRA. Not too shabby, eh?
One final note about these Roth IRA rules: For married people, you can only contribute the maximum of $4,000 or $4,500 if your combined income is less than $150,000.
If you are single or head of household, you can contribute the maximum if your income is less than $95,000.
For most middle-class folks looking for a perfectly legal way to permanently avoid tax (rather then merely temporarily postpone tax), the Roth IRA fits the bill.
Now comes the hard part -- how to actually implement this tax avoidance strategy.
"We'd like to save as much as we can for our golden years. But $9,000 a year? It's hard to put aside that kind of money. We need every dollar we make just to pay the bills."
If that's your situation, I'm not going to get up on my "what-do-you-mean-you-can't-save-any-money-for-retirement" soapbox and start preaching at you.
I will say this: You've got to start somewhere, and you've got to start saving something, don't you?
People who have a problem saving for retirement usually have a budgeting problem. For an excellent resource on budgeting, I highly recommend the Budget Stretcher web site:
This site offers a free budget system complete with simple forms and worksheets to help you figure out how to put some money aside for a Roth IRA or other savings plan.
Take advantage of this resource and get started today.
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About the AuthorNick Niesen
Joined: April 29th, 2015
Articles Posted: 33,847
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