Income taxes, while not popular are an important part of everyone's
financial life. They can be a complicated issue that many just accept as part
of the cost of living in America. While the top marginal federal income tax
rate has dropped from 70% in the early 1980s to 35% for 2004, almost everyone
feels they pay more in tax than they would like.
And it is not just federal income taxes. Your income ends up being subject
to state, Social Security, Medicare and, in some cases, local or city taxes.
All in all, most Americans end up paying from one fifth to one half of their
income to some governmental body.
Be tax wise, not tax driven
Making financial decisions based only on the income tax implications is
almost always a bad idea. The key is to have an understanding of the tax
implications and factor them into your decision-making process.
Tax Advantaged
The most common form of tax advantaged investing is using the beneficial
income tax rates applied to long-term capital gain. If you own stock, for
more than one year, and sell the shares for a gain, the maximum income tax
rate on that gain is 20%. This compares with the top rate of 35% (for 2004)
on other types of regular income and on gains on investments held for less
than one year. Be sure to remember this if you are considering selling shares
close to that one year anniversary of your purchase. The lower rates on
qualifying long term capital gains apply to all transactions in 2004.
Tax Free
The most common type of tax free investing is with the purchase of tax free
bonds issued by a municipal, state or local government agency. The tax laws
provide that most types of these bonds are exempt from federal income taxes.
However, they may be subject to state or local income taxes. Be sure to ask
your financial advisor about this. Because interest from these types of bonds
is not subject to federal tax, they often pay a lower interest rate than
other taxable bonds of similar quality and duration. Compare your after tax
returns to make sure tax free bonds are right for you.
Tax Deferred
Another less well known, but very powerful, tax reduction strategy is to
position your funds so any tax on earnings or appreciation is deferred until
later. This results in your ability to continue to earn returns on money that
would have otherwise been paid in taxes. With a tax-deferral strategy, you
still have to pay the tax some day, but you control when that day is and the
power of compounding results in more money in the long run.
Two of the most common ways to take advantage of income tax deferral are
through the use of Individual Retirement Accounts and certain insurance
contracts called annuities. Below is an example that demonstrates this point
with an IRA.
Example. Robin is 30 years old and wishes to save for
retirement. In this example her combined federal and state income tax rates
are 33% (28% for federal and 5% for state income taxes). She is evaluating
the benefits of $2000 annual contributions to a "regular" IRA
compared to simply saving $2000 each year in a bank account.
In this example, lets ignore any aspects of deductibility of her IRA
contributions and assume the same earnings rate of 6% for the IRA and the
bank account. For the IRA option, there are no taxes due annually, but they
must be paid when money is withdrawn. For the bank account option, income
taxes are paid annually, reducing her after tax return to 4%. The example
assumes the additions to the IRA and the bank account take place at the end
of the year.
The key question is how much money Robin will have at age 60 after all
taxes are taken into account.
Year |
Total
Contributions |
IRA
Value |
Bank Account Value
|
1 |
$2,000 |
$2,000 |
$2,000 |
2 |
$4,000 |
$4,120 |
$4,080 |
3 |
$6,000 |
$6,492 |
$6,492 |
4 |
$8,000 |
$9,012 |
$8,494 |
5 |
$10,000 |
$11,734 |
$10,832 |
10 |
$20,000 |
$28,974 |
$24,012 |
15 |
$30,000 |
$54,304 |
$40,048 |
20 |
$40,000 |
$91,524 |
$59,556 |
30 |
$60,000 |
$226,566 |
$112,170 |
Taxes Due |
|
- $54.967 |
None |
Net After Tax |
|
$171,599 |
$112,170 |
As the chart shows, Robin will be almost $60,000 ahead by deferring taxes
with the IRA option. However, what happens if Robin is in a higher income tax
bracket in year 30 when she takes out the money. If Robin's tax bracket
increases to the top federal bracket of 35% and her state rate is 5%, she
would pay taxes of $66,626. This would still leave her with $159,940, or
almost $48,000 further ahead.
Taking full advantage of the higher IRA contribution limits would make an
even greater difference.
Tax deferral is a very powerful wealth building tool.
