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In last week’s column, I talked about the tax treatment of various types of dividend payments … and toward the end, I said you could avoid most of the issues by investing in a tax shelter.
I realize that when a phrase like “tax shelter” comes up, most people think of shady businesses … secret bank accounts on tropical islands … or other sophisticated schemes. But the reality is that plenty of tax shelters are available to all of us — and there is simply nothing suspicious or illegal about them.
Take Individual Retirement Accounts, or IRAs. Nearly everyone has heard of them, loads of Americans use them to save and invest, and yet they ARE, technically speaking, tax shelters.
Better Yet, You Still Have Time to
Open or Fund an IRA for LAST YEAR!
I’ll explain why in a minute. First, let’s back up and talk in broad strokes.
Like 401(k)s, IRA plans were created by amendments to the Internal Revenue Code. And they serve much the same purpose — allowing individuals to sock away money for retirement and reap tax benefits in the process. But they come in many more flavors than 401(k) plans.
The two biggest categories are traditional IRAs and Roth IRAs.
With traditional IRAs:
- You contribute pre-tax money and thus save on your current taxes by lowering your taxable income …
- Your contributions and earnings will be subject to taxation upon withdrawal …
- And you must stop contributing and begin withdrawing money at age 70½.
Meanwhile, with Roth IRAs:
- You contribute after-tax money and thus gain no upfront tax-savings benefit. But …
- Your contributions — and earnings — will never be taxed again, so long as you meet the basic guidelines (eligible age of 59½ and held for at least five years)!
- Plus, you can continue socking away money as long as you have earned income, no matter what your age. And you never have to make minimum withdrawals, even if you live to be 110.
Now, BOTH of these account types:
- Give you a huge range of investment choices, pretty much everything offered by your broker …
- Can be funded until tax day of the following year. In other words, you can put money in for 2011 as late as this coming April 15!
- Allow catch-up provisions for contributors over the age of 50. In 2010 the regular limit for either IRA is $5,000 and $6,000 for age 50+.
However, it’s important to note that you can only contribute to a Roth IRA if your Modified Adjusted Gross Income (MAGI) falls within certain levels. Here they are for 2011:
If you file as a single taxpayer, you have to make less than $107,000 to make the maximum contribution. You can make a partial contribution if your MAGI is between $107,000 and $121,999. And you’re barred from making any contribution to a Roth IRA if you earn more than $122,000.
Meanwhile, if you’re married and file jointly, your MAGI has to come in below $169,000 for the maximum contribution. You can make a partial contribution with MAGI between $169,000 and $179,000 but nothing above that range.
Regular IRAs, on the other hand, have no income restriction for contributions, though the tax deductibility can be affected by your MAGI and whether or not you’re covered by a retirement plan at work.
All these reasons are why Uncle Sam gives you until tax day of the following year to fund an IRA — because there may be no way for you to determine which IRA to use or fund for a given year until you finalize your taxes!
There are no age restrictions for Roth IRAs — as long as you have earned income you can start socking away money. Your ability to contribute is also unaffected by any retirement plan you might have through your employer.
Just remember that you cannot max out both a regular and Roth IRA in the same tax year. Your total contributions to all IRA accounts (not counting rollovers and such) must fall within the aforementioned ranges.
Speaking of rollovers …
There Are Other Types of IRAs Beyond the Most Common Ones
Rollover IRAs act just like traditional IRAs but they’re funded by converting other retirement plans such as 401(k) plans.
In other words, if you leave your current employer (for any reason) you don’t have to keep your money parked in their retirement plan. Instead, you can convert it into an IRA account instead. Some of the advantages of doing so include easier account management and greater investment choices.
For the self-employed, there are also SEP IRAs and Simple IRAs. Both types allow small businesses or self-employed individuals to sock away money in lieu of establishing pension plans.
Personally, I prefer the Solo 401(k) to either of these options, but that’s a story for another time.
Last but not least, there are also self-directed IRAs, which allow you to invest in a broad range of items, including real property such as land and houses. Plenty of exclusions apply — for example, you can’t buy a house in your IRA and rent it to yourself — but sophisticated investors wishing to invest in “non-traditional” assets should take a closer look at these plans.
Some Quick Words on Selecting
The IRA That’s Right for You …
Obviously there’s no way for me to know your personal situation, and it might be best to consult a professional who can speak to your particular goals and circumstances.
But if I had to come up with some general guidelines, here’s what I’d say:
- If you have a 401(k) plan through your employer, I still suggest contributing to that first … at least up to the point where you get the maximum match.
- If you’re self-employed, look into the Solo 401(k) before you do anything else.
- If you have additional money to sock away, I would then opt for an IRA … preferably the Roth if you qualify.
By following this simple arrangement, you will be taking advantage of as much “free money” as possible. You will benefit from a solid upfront tax advantage. And by contributing additional funds to the Roth IRA you are basically hedging your tax bets going forward.
Besides, given the ability to roll over 401(k)s into IRAs … and the relaxed rules for converting traditional IRAs into Roth IRAs … this basic plan also gives you the maximum flexibility going forward.
Best wishes,
Nilus
P.S. My own family members use IRAs to shelter much of their retirement savings from taxes. And if you want to know exactly what investments I’m telling my father to put into his IRA, just click here now.
