CHAPTER 7 Into Thin Air - certifiedtaxcoach

CHAPTER 7

Into Thin Air

Creating Income with Less Tax

By Robert Henderson Jr., CFP?, CTC

T hroughout this book, we have solved many mysteries about financial planning. Many of the clues we have seen have led to the same conclusion: you can save a lot of money on taxes by simply shifting your expenses into deductible categories. This allows you to reduce your overall tax burden while saving money on expenses you would be paying anyway, and it's a smart tax strategy for business owners in particular as the available deductions are so valuable.

Tax planning is not limited to this strategy, however. A clever tax detective knows that there is another powerful method for minimizing your taxes: growing your wealth through tax-free income. This is the cornerstone of retirement planning, and it builds upon some of the principles we investigated in earlier chapters.

Let's look at some clues for how you can create tax-free income with a smart investment strategy.

Four Types of Investment Accounts

The point of retirement planning is to secure a healthy financial future by setting aside money to use after you've left the workforce. For

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The Tax Detective

most people, retirement planning is also a method for growing wealth in order to establish a family legacy: the money that's not spent during your retirement passes forward to your heirs, who in turn can grow that wealth through additional investments.

It is certainly possible to save for retirement simply by socking money away in a drawer, but that is not a very efficient system. Successful retirement planning requires an investment. When you invest, your money grows in value, allowing you to reach much greater wealth than you could otherwise.

With that in mind, the first clue that you discover when exploring retirement plans is that not all investments are created equally. Some types of investment accounts will yield much greater rewards than others when it comes to tax planning. Understanding your options allows you to choose the best strategy for your financial plans.

In general, there are four main ways that the money you invest can be taxed, and the type of investment account you use determines the taxes you pay. Let's investigate these to see whether we can find a few clues about which investments are the most tax-friendly.

Taxable All the Time

Some investments offer very few tax benefits. You must pay tax on the money in these accounts every year, not just when the money is withdrawn for use. Depending on the type of investment, you may be taxed for capital gains rather than income, but you will still face a tax bill. Many common investments are taxed this way:

? Bank CDs

? Savings accounts

? Mutual funds

? Stock-trading accounts

Many of these investments are more commonly used for income than retirement planning due to their tax structure. They are not necessarily designed well for long-term investments since you will be

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stuck paying taxes on their gains. While such investments do have their place, they are not very tax-efficient. When it comes to setting money aside for retirement, there are much better options.

Tax-Deferred

Some investment vehicles allow you to invest and grow wealth without incurring any taxes. Taxes are due when you withdraw money from these accounts. Two common examples are annuities and non-deductible, traditional IRAs.

A tax-deferred investment can become an integral part of a smart tax strategy, but it can also be problematic, as you never know for sure what the future may hold. If you withdraw money at a time when your income is low, you won't need to pay much in taxes. If, however, you must withdraw money while your income from other sources is high, you can lose a substantial amount of your investment.

One helpful thing to remember about tax-deferred accounts is that you will only be taxed on the gains, not your basis. In other words, the money that you initially paid into the account will not be subject to any additional taxes. This makes these accounts useful in some contexts, but they should never be your first choice when looking to set aside money for long-term growth.

Deductible Contributions

These investment wrappers allow you to place pre-tax dollars into an investment that then grows in a tax-deferred environment until you are ready to withdraw the funds. We have touched on these investments in the past as they are very popular retirement planning options. Here are a few of the most common plans utilizing deductible contributions:

? Traditional IRAs ? 401(k)s ? SEPs

You may notice that these plans are common vehicles for employer-sponsored retirement accounts. This is because the tax-deductible

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nature of contributions makes them very attractive to businesses looking to trim costs. From the perspective of an individual, however, these accounts can leave something to be desired.

As we discovered earlier, tax-deferred accounts can be a gamble. If you can put off your withdrawals until you have reached a lower tax bracket, you can enjoy some tax savings. However, if your investments do well, you will still lose a large chunk of your wealth to taxes.

You face another problem with traditional IRAs: if you pass away before exhausting the funds within the IRA, your heirs will be taxed both income tax and inheritance tax on the money inside. This makes a traditional IRA a terrible vehicle for estate planning.

You can avoid these issues by moving some of your most valuable tax-deferred assets into a tax-exempt wrapper. Let's investigate that option now.

Tax-Exempt

A tax-exempt investment is one that uses after-tax contributions as the basis for the investment. You get no deductions for putting money in, but once invested, you will never be charged for the interest these investments earn. When you withdraw funds, you will not have to pay any taxes. This concept is often referred to as "paying taxes on the seed rather than on the harvest." For example, imagine you wake up one day, and you are a farmer. The tax collector gives you two options for paying taxes: (a) pay tax on the seed or (b) pay tax on your crop (harvest) after it has grown and become plentiful. Which option do you choose? By paying taxes on the seed now, you are paying taxes on a smaller amount because the seeds have not produced a harvest yet. When the harvest comes, no taxes are due.

The best-known tax-exempt investment is the Roth IRA. Another option, which you may not have considered, is investment-grade life insurance. We will look at insurance in greater depth shortly. For now, let's focus on the Roth IRA.

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Like a traditional IRA, a Roth IRA is the vehicle for cash investments. The actual nature of the investments is up to you: you can use the funds in an IRA to buy stocks, bonds, even real estate. Since Roth IRAs are so powerful, they have a yearly contribution cap of $5,500 if you are under age 50, or $6,500 if you are age 50 or older, according to 2015 contribution rules. You can only utilize a ROTH IRA if your income is below $122,000 for an individual or $188,000 for a married couple filing jointly.

Just How Powerful Is a Roth IRA?

To get an idea of just how valuable the tax-free wealth generation of a Roth IRA can be, let's look at a couple of examples. One real-life success story concerns Max R. Levchin, the founder of Yelp. Before his company grew to its current size, he filled a Roth IRA with shares. Now, that those shares are worth more, the value of the IRA has grown to an astonishing $95 million, and he won't need to pay a cent in taxes as long as he waits until he turns 59 and a half before withdrawing the money and has satisfied the 5-year contribution period. Moreover, any money he leaves in that Roth IRA will pass to his children tax-free after his death.

Of course, most of us don't have ownership of a massive company with such valuable shares, but we can still benefit f rom t he t ax-free growth of wealth accumulated in a Roth IRA. Look at it this way: if you started with just $1 in an investment that doubled each year over a 20-year period, you would end up with $1,048,076. If that same investment were taxed every year as regular income, you would walk away with just $127,482 after 20 years!

Roll Over Your Assets

Seeing the power of a Roth IRA in action brings us to the next mystery: how can you incorporate a Roth IRA into your current financial plan? After all, many people already have retirement accounts set up through their employers, and as we have seen, those accounts are not always the most tax-advantageous options. Fortunately, there

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