Utilize a combination of several different investment options to achieve your future goals depending upon the level of risk you are comfortable with and the corresponding rate of return related to that level of risk. Options to consider are savings accounts, certificate of deposits, mutual funds, a 401(k), a 403(b), Traditional IRAs, Roth IRAs, Educational IRAs, savings bonds, life insurance products, and stock investments. Balance the use of the options that require you to pay taxes now, pay taxes later, or pay no taxes.
Savings accounts and CD's are safe secure investments that receive taxable interest returns from the bank at an advertised rate typically from 3% to 7%. The interest rates for savings accounts fluctuate each month, but the interest rates for CD's do not. The interest rates for CD's are higher than the interest for savings accounts because the money is locked in the bank for a time period specified when opening the account. The interest rate does not change, but bank penalties will occur if the CD is redeemed before the due date. Investments in savings accounts and CD's do not have limitations on the amount of money that can be invested, but they require taxes to be paid each year on the interest earnings received. Savings accounts and CD's should only be considered for short-term needs and growth. Any money that can be invested with the intention of not being used for at least 3 should be invested in an investment that may yield a higher rate of return.
Mutual funds consist of stocks from many different companies with the intent of minimizing overall risk by investing in multiple companies. If one company suffers a loss, the entire fund will not suffer because many other companies will probably have a gain. Different funds offer different risks from very low to very high. The higher the risk the greater the rate of return, the lower the risk the lower the rate of return.
The interest received from your savings/CD account is taxable every year at your current tax bracket. Therefore, if you received $100 interest for the year and you are in the 28% tax bracket, then you will give $28 of that money to the IRS. Mutual funds are not taxed the same. Instead you are taxed only on the dividends and capital gains received, not on the increase of stock value. The dividends are a distribution of a company’s surplus or earnings passed onto the stockholders. The dividends are known as a realized gain, which is taxable. The capital gain of the mutual fund is only taxed when the money is withdrawn. Therefore, a mutual fund yielding a consistent return of 10% per year paying no dividends will not be taxed on the gains until withdrawn, while a savings/CD account yielding a 5% return will be taxed on the gains every year. The mutual funds can thus provide a higher return on your money. The increase in value is known as an unrealized gain, which is not taxable. The increase in value will only become a realized gain when sold. Due to recent changes in the tax law, the capital gains received from the sale of a stock or mutual fund can be taxed at a lower rate than your tax bracket as long as the investment is considered to be a long-term gain held for more than one year. The interest received from a savings account or CD is not provided the same tax advantage.
The government has decreased the taxes to be paid for capital gains. Capital gains are the increase in the value of an investment above the original purchase price. For instance, if you purchased a mutual fund for $1000, but sold it for $1200, you will pay capital gains taxes on the $200 increase. Assets owned 12 months or less will be taxed at your current tax rate. Assets owned more than 12 months will be taxed at a lower rate since it is considered a long-term investment at a maximum rate of 15% for individuals in a tax bracket higher than 15% while those in the 15% tax bracket will be taxed at 10% and those in the 10% tax bracket will be taxed 5%. Therefore, consider the tax consequences when selling assets because you can save yourself hundreds and even thousands of dollars by waiting until you qualify for the lower tax rate. Also, when selling a portion of your investment, specify the oldest shares be sold to take advantage of the reduced capital gains. Consider any distributions provided by the mutual fund company will require taxes to be paid for that tax year at your current tax rate. Those distributions are different than the capital gains when the shares are sold.
A 401(k) is a tax-deferred qualified investment offered through many employers allowing employees to contribute a portion of their income every paycheck into a variety of investment funds. The employers may also provide a contribution consisting of a portion of the employee contribution up to a maximum amount stated in the employee's handbook. The investment reduces your taxable income by making the contribution before calculating federal taxes. The contribution does not reduce social security, medicare, or state taxes. Withdrawals cannot be made until after age 59 1/2 and will be taxed at your tax rate at the time of withdrawal. If a withdrawal occurs before age 59 1/2 then you will be taxed and you will be penalized 10% of the amount withdrawn. Always contribute at least the minimum into your 401(k) to receive the maximum matching contribution from your company. The matching funds are free/extra money from your company offering an immediate return on your investment allowing more money to work for you over a longer period of time. The intention of investing in a tax-deferred investment is that your tax bracket at the time of withdrawal will be lower than your current tax bracket. If your goal is to reduce your current taxes without concern of your future taxes, then contribute the maximum you can to your 401(k). The amount invested cannot exceed $14,000 per year (2005 tax year and will increase in subsequent years). The maximum is scheduled to increase in subsequent years. Be sure to consider the fact that distributions from a 401k will be taxed at your tax rate at the time of withdrawal compared to the 15% maximum tax rate for mutual funds. Therefore, consider which option is best suited for your goals.
A 403(b) is a qualified investment similar to a 401(k) in relation to the tax benefits, but is available only 501C-3 organizations that can include churches, hospitals, and schools. The employee is able to lower their taxable income by taking a reduction in pay to fund their 403(b) retirement account. Contributions cannot exceed 25% of your income up to a maximum of $14,000 per year (2005 tax year and will increase in subsequent years).
The Traditional IRA offers tax-deferred growth, but with different limitations than the 401(k). It allows for a maximum contribution of $4,000 per year (2005 tax year and will increase in subsequent years) per individual depending upon your Adjusted Gross Income (AGI). The maximum contribution is scheduled to increase in subsequent years. All or a portion of the invested amount can be tax deductible and is also dependant upon your AGI and participation in another qualified retirement account. Contributions can be made to the Traditional IRA even though you are participating in an employer sponsored retirement plan. Although you may not be able to receive a tax deduction. The amount invested for the year cannot be greater than your earned income if less than the maximum contribution allowed for the year. For instance: someone earning less than $4,000 for the year must contribute less than $4,000 for that year. The funds cannot be withdrawn until 59 1/2 unless a 10% penalty is applied. All funds withdrawn will be taxed at your current tax bracket. Although, the funds can be withdrawn prior to 59 1/2 without a penalty, but after paying taxes if death or disability occurs or to be applied towards the purchase of a first time home purchase up to $10,000 or for educational purposes without a maximum. The funds must begin to be withdrawn by age 70 1/2 to avoid another penalty. Refer to IRS Publication 590 - Individual Retirement Accounts (IRAs) for further information.
The Roth IRA is a new form of an IRA introduced in 1998 that also offers tax-deferred growth, but with different withdrawal limitations and the investment must consist of many that has already been taxed. Investments to a Roth IRA can be made even though contributions have been made to a Traditional IRA or to an employer sponsored retirement plan as long as the total contribution per individual to any IRAs for the year does not exceed $4,000 (2005 tax year and will increase in subsequent years) and your AGI meets certain requirements. The amount invested for the year cannot be greater than your earned income the same as a Traditional IRA. The gains can be withdrawn the same as a Traditional IRA without a tax penalty and without paying taxes only after the Roth IRA has been existence for five years and after age 59 1/2. There is also no penalty if the funds are not withdrawn by age 70 1/2. The amount invested into a Roth IRA can be withdrawn anytime without penalty or paying taxes, even prior to age 59 1/2 because only the gains are taxes while the contributions have already been taxed. If the contributions are more than the value of the account, then the account will be liquidated and closed without any penalties. You also cannot declare a capital loss on your taxes due to the negative return. Refer to IRS Publication 590 - Individual Retirement Accounts (IRAs)for further information.
Specific educational related investments exist offering different advantages and disadvantages that are too numerous to summarize in this section. Therefore, refer to IRS Publication 970 - Tax Benefits for Education for further information to determine which route would be best suited for your goals.
Contributions to an IRA can be made for the previous year as long as the investment occurs by April 15th (the day taxes are due) and the contribution is applied/indicated as an investment for the previous year. Contributions can then also be applied towards the current year's investment. Thus, an individual can invest $6,000 to an IRA within the same year. Any contribution higher than the stated maximum will result in a penalty (refer to the IRS for further information). Any IRA account can be opened through the same companies offering mutual funds because IRA's are mutual funds. The only difference is the application form or an option on the application form that fulfills the IRS tax code regulations.
U.S. Savings Bonds are a conservative tax-deferred investment, earning about 3% - 6%, with the opportunity to be a tax-free investment. The interest earned is accrued on a tax-deferred basis until redeemed. If you intend to keep money in a savings account for a couple of years, consider purchasing U.S. Savings Bonds as opposed to storing your money in a bank CD. Savings Bonds can be purchased in increments of $25 while a CD account must be opened with at least $500. A Savings Bond requires a commitment of at least 6 months, similar to a CDs commitment. Savings Bonds allow the funds to accrue tax-deferred at a rate similar to most CD's with the opportunity of withdrawing a portion of the investment when needed, not the full amount. The result will be a reduction in the amount of taxes paid each year due in the interest received only on the portion redeemed. The U.S. Savings Bonds can also be redeemed tax-free if used for an educational purpose in the year of redemption. U.S. Savings Bonds can be purchased and redeemed at most any bank or credit union.
The cash value offered with many life insurance policies also provides for tax-deferred growth. A portion of the insurance premium pays for the insurance and the company's administrative expenses, while the remaining amount is placed into an account that grows without having to pay taxes each year. The cash value of a life insurance policy may be withdrawn as a loan anytime tax-free depending upon restrictions stated within the policy. The policy states you can take a loan on the cash value, but there is no rule requiring you to pay back the loan. Instead, the investment return associated with the cash value will pay the interest for you. The restrictions are based on IRS regulations because the IRS always wants you to pay taxes. Refer to the Important factors to consider before choosing a life insurance product section in this chapter for further information and restrictions associated with life insurance products.
A consideration for investing in stocks without having to pay the capital gains taxes each time a sale occurs and to not pay the capital gains at all is to purchase stocks through a Roth IRA. Simply open a Roth IRA account with a brokerage, fund the account, then trade stocks through that Roth IRA. The trading of stocks will then become a tax-deferred investment. Limitations to this technique are that if the stock is traded at a loss, then you cannot declare that loss as a capital loss each tax year. You are also limited to the funding and withdrawal rules for a Roth IRA. The advantage of using a Roth IRA to trade stocks is the tax-deferred savings when attempting to time the market or when wanting to own a stock for a short period of time. You would then be able to sell shares at a high price, then purchase more shares at a lower price without suffering any tax consequences until the time of withdrawal that provides you an opportunity to earn a greater return on your investment.
The 10% early withdrawal penalty for a 401(k) and a Traditional IRA can be avoided because of the IRS 72(t) Substantially Equal Periodic Payments tax code. Further information and to determine the calculations and strategy should be discussed with a tax professional.
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