If anyone asked me two keys to retiring in financial comfort, my first response would be to start saving early and let time work its magic. My second answer would be to take advantage of retirement accounts and the tax breaks that come with them.
Most full-time workers contribute to a 401(k) plan because it is offered by their employer and they are automatically enrolled there. Unfortunately, far fewer (37% of households) have a individual retirement account (IRA) and enjoy the benefits they can bring.
There are two main types of IRAs: traditional and Roth. Ultimately, the difference between the two comes down to when you get your tax relief, and that’s usually how people choose between the two. With a traditional IRA, you get tax relief with a tax deduction, but you’ll have to pay taxes on withdrawals in retirement, which are necessary from 72 years old. With a Roth IRA, you contribute after-tax money, with the ability to make tax-free withdrawals once you turn 59½.
The maximum you can contribute to both IRAs, both Roth and traditional combined, is $6,000 per year ($7,000 if you’re 50 or older). If you are eligible to use a Roth IRA, you should definitely consider it as it can make capital gains taxes irrelevant.
It pays to use a Roth IRA
To really see how useful it can be for your investments to be compounded tax-free, let’s imagine there are two people, one investing in a brokerage account and one investing in a Roth IRA. If the two people invested $6,000 per year for 20 years, receiving average annual returns of 10%, they would have approximately $343,650. The person who used the Roth IRA would receive the full $343,650 (if eligible), but the person who used the brokerage account would have to pay taxes when they sold the shares.
Since they personally only invested $120,000 over 20 years, $223,650 would be capital gains ($343,650 minus $120,000). Assuming they earn $40,400 or more per year, the minimum they would pay in capital gains taxes is 15%, which would be over $33,500.
The money saved on taxes in retirement can easily run into the tens of thousands of dollars. It’s not far-fetched for someone who uses a Roth IRA their entire career to accumulate around $1 million in retirement. Of this amount, hundreds of thousands are likely to be capital gains. At a capital gains tax rate of 15%, that’s $15,000 for every $100,000 of capital gains.
Enjoy while you can
For younger investors who may be earlier in their career, it makes more sense to opt for a Roth IRA and pay taxes on the money now while you’re in a lower tax bracket rather than later in the year. your career when your tax bracket is likely to be higher. As you progress in your career, you may also find yourself ineligible for a Roth IRA due to its income limit.
To be eligible to contribute to a Roth IRA for the 2022 tax year, you must earn less than $144,000 if you’re single, $214,000 if you’re married and filing jointly, and $10,000 if you’re married and filing separately. Once you cross that threshold, you can still use a Roth IRA, you just have to go with the Roth IRA backdoor itinerary. A backdoor Roth IRA is when you contribute to a traditional IRA — which has no income limit — and then convert it to a Roth IRA. There is an income limit on Roth IRA contributions, but not on conversions.
A piece of the puzzle
Due to the relatively low contribution limit, IRAs are best used as retirement income supplement as your main source of income. Yet, given enough time and consistency over a career, they can play a huge role in your retirement finances. If you accumulated $300,000 of stocks in your Roth IRA that pay an average dividend yield of 2.5%, that would be $7,500 tax-free. annual dividend income. You can’t survive on this alone, but an extra $7,500 a year would be good for anyone.
The IRS isn’t known for granting breaks in many areas, but retirement is one of them. As you save for retirement, you might as well benefit from tax relief along the way. There is no doubt that you will be glad you did.
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