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Priority 2: Tax-Advantaged Money

There are two different types of tax-advantaged vehicles or accounts: tax-eliminated accounts and tax-deferred accounts. Your choice of which account is better mainly depends on your current income and your estimation of your future tax rates. If you expect your tax rates to be higher in the future than they are now, you will save a greater amount for retirement if you choose a Roth IRA or Roth 401(k) versus the traditional. If you expect your tax rates to be lower in the future than they are now, you will save a greater amount for retirement if you choose a traditional IRA or 401(k). To help you decide which type of IRA is more beneficial for you, see Learning Tool 28: Roth versus Traditional: Which Is Better for You in the Learning Tools directory of this website. It allows you to set an annual contribution, an estimate for a rate of return on earnings, and your current and future tax rates. By changing your future tax rates, you can determine if your balance in the future would be higher or lower, all other areas being held constant.

Tax-eliminated accounts: Tax-eliminated accounts require you to pay taxes on principal before you invest it; however, you do not have to any pay any taxes on the capital gains or earnings in the future. There are several different tax-eliminated investment vehicles that can help you save for retirement (i.e., Roth IRAs or Roth 401(k)) or for education (i.e., 529 funds, Education IRAs and Series EE or I bonds). When tax-eliminated accounts are used for qualified purposes, withdrawals can be made without penalty and without taxes.

With a Roth IRA or a Roth 401(k), you pay taxes on the principal before you deposit the money into your retirement account. Once you reach age fifty-nine and a half, you can take both the principal and interest out of this retirement account without paying taxes on the money. By paying taxes beforehand, you eliminate taxes on all capital gains and earnings in this account. Roth IRAs have an additional advantage: if you need to use the funds in your account before retirement, you can withdraw the principal without penalty because you have already paid taxes on the principal. The disadvantage of a Roth IRA is that, like all retirement accounts, you cannot withdraw your earnings without penalty until you are at least fifty-nine and a half years old.

With many 529 funds and Series EE and I bonds, you are investing with after-tax dollars. If you use your earnings to cover qualified educational expenses for your children, you do not have to pay taxes on the earnings. However, if you do not use the earnings for qualified educational expenses, you must pay a 10-percent penalty on your earnings, as well as federal and state taxes on that withdrawal as it is considered ordinary income for tax purposes.

Tax-deferred accounts: Tax-deferred accounts allow you to invest without first paying taxes on the principal; then, when you withdraw money from the account at retirement, you pay taxes on both the principal and the earnings. This type of account is advantageous because it allows you to invest a larger amount of money using a smaller percent of your net income. Examples of tax-advantaged investment vehicles include Individual Retirement Accounts (IRAs), 401(k) and 403(b) plans, and Simplified Employment Plan Individual Retirement Accounts (SEP-IRAs).

Suppose your gross income last year was $45,000, and you invested $3,000 in a traditional IRA. Your adjusted gross income (the income on which you pay taxes) would be $42,000 ($45,000 less the $3,000 contribution). Contributing to an IRA reduces the amount you must pay in taxes today (the amount of your tax savings would be equal to $3,000 multiplied by your tax rate). However, when you retire after age fifty-nine and a half and take this money out of your retirement accounts, you are not only required pay taxes on your $3,000 investment, but you must also pay taxes on any earnings the IRA investment has produced, as well.

The risk of using tax-deferred investment vehicles is that you must be at least age fifty-nine and a half to make withdrawals. If you withdraw funds before you reach this age, you must pay taxes on the funds at your ordinary income-tax rate (this rate can be as high as 35 percent), and you must also pay a 10-percent penalty fee. Thus, if you make early withdrawals, you may lose up to 45 percent of your investment in taxes (a 10-percent penalty charge plus 35 percent in taxes if you have the highest marginal tax rate possible). Tax-deferred earnings that have remained in your retirement account for more than twelve months are taxed as ordinary income, which is taxed at a higher rate than capital gains.


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