One of the best ways to be more efficient with your retirement savings is using tax-advantaged accounts. If you’re going to be saving for retirement — and you should absolutely be — you might as well get some tax breaks in the process. While a 401(k) plan is offered through your employer, an IRA must be opened on your own, similar to a regular bank or brokerage account.
There are two types of IRAs: Roth and traditional. Although you technically contribute after-tax money into a traditional IRA, your contributions may be deductible, depending on your income, filing status, and whether or not you’re covered by a retirement plan at work. Your contributions to a Roth IRA aren’t tax-deductible, but you can take tax-free withdrawals in retirement.
People are also reading…
For 2022, the maximum contributions to an IRA (both Roth and traditional combined) is $6,000 ($7,000 if you’re 50 or older). If you’re eligible to contribute to a Roth IRA, it’s in your best interest to take advantage of it. This is especially true if your current tax bracket is lower than what you anticipate your tax bracket will be in retirement. It’s better to pay taxes now while your rate is lower than later when it may be costlier.
It pays to use a Roth IRA
The main reason to use a Roth IRA is the money you can potentially save in taxes. To really get a picture of just how much you can save in taxes by using a Roth IRA, let’s imagine a scenario in which two people make $500 monthly contributions into a fund that returns, on average, 10% annually for 25 years. During that time, the investment would’ve accumulated to over $590,000, although they would have only personally invested $150,000.
If one person invested in a Roth IRA, all $590,000 would be tax-free upon withdrawal (as long as they’re at least 59 1/2 years old). If the other person invested in a regular brokerage account, the $440,000 in capital gains would be taxed. At a 15% capital gains rate, that’s over $66,000 in taxes owed; if you’re in the 20% bracket, that’s $88,000 owed. Depending on how well your performing investments, utilizing a Roth IRA could save you six figures in taxes.
For 2022, the capital gains tax rates are:
|Filing Status||0% Rate||15% Rate||20% Rate|
Single or married, filing separately
The “80% rule” states that you should aim to have around 80% of your pre-retirement annual income in retirement in order to maintain your current lifestyle. If you’re using that rule of thumb, $66,000 and $88,000 in saved taxes could be a year’s worth of retirement income for someone making $82,500 and $110,000, respectively. It pays to utilize a Roth IRA before investing in a brokerage account.
10 stocks we like better than Walmart
When our award-winning analyst team has an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisorhas tripled the market.*
They just revealed what they believe are the ten best stocks for investors to buy right now… and Walmart wasn’t one of them! That’s right — they think these 10 stocks are even better buys.
Stock Advisor returns as of 2/14/21
The Motley Fool has a disclosure policy.