Investing All-in-One For Dummies. Eric Tyson

Investing All-in-One For Dummies

sock away these kinds of contributions.

Some employers are offering a Roth 401(k) account, which, like a Roth IRA (discussed in the next section), offers employees the ability to contribute on an after-tax basis. Withdrawals from such accounts generally aren’t taxed in retirement.

If you’re self-employed, you can establish your own retirement savings plans for yourself and any employees you have. Simplified Employee Pension-Individual Retirement Accounts (SEP-IRAs) allow you to put away up to 20 percent of your self-employment income up to an annual maximum of $58,000 (for tax year 2021).

Individual Retirement Accounts

If you work for a company that doesn’t offer a retirement savings plan, or if you’ve exhausted contributions to your company’s plan, consider an Individual Retirement Account (IRA). Anyone who earns employment income or receives alimony may contribute up to $6,000 annually to an IRA (or the amount of your employment income or alimony income, if it’s less than $6,000 in a year). A nonworking spouse may contribute up to $6,000 annually to a spousal IRA.

Your contributions to an IRA may or may not be tax-deductible. For tax year 2021, if you’re single and your adjusted gross income is $66,000 or less for the year, you can deduct your full IRA contribution. If you’re married and you file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $105,000 per year or less.

If you can’t deduct your contribution to a standard IRA account, consider making a contribution to a nondeductible IRA account called the Roth IRA. Single taxpayers with an AGI less than $125,000 and joint filers with an AGI less than $198,000 can contribute up to $6,000 per year to a Roth IRA. Although the contribution isn’t deductible, earnings inside the account are shielded from taxes, and unlike withdrawals from a standard IRA, qualified withdrawals from a Roth IRA account are free from income tax.

Should you be earning a high enough income that you can’t fund a Roth IRA, there’s an indirect “backdoor” way to fund a Roth IRA. First, you contribute to a regular IRA as a nondeductible contribution. Then, you can convert your regular IRA contribution into a Roth IRA. Please note that this so-called backdoor method generally only makes sense if you don’t have other money already invested in a regular IRA because in that case, you can’t simply withdraw your most recent contribution and not owe any tax.

Annuities: Maxing out your retirement savings

What if you have so much cash sitting around that after maxing out your contributions to retirement accounts, including your IRA, you still want to sock more away into a tax-advantaged account? Enter the annuity. Annuities are contracts that insurance companies back. If you, the investor (annuity holder), should die during the so-called accumulation phase (that is, before receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment.

Annuities, like IRAs, allow your capital to grow and compound tax-deferred. You defer taxes until you withdraw the money. Unlike an IRA, which has an annual contribution limit of a few thousand dollars, an annuity allows you to deposit as much as you want in any year — even millions of dollars, if you’ve got millions! As with a Roth IRA, however, you get no up-front tax deduction for your contributions.

Because annuity contributions aren’t tax-deductible, and because annuities carry higher annual operating fees to pay for the small amount of insurance that comes with them, don’t consider contributing to one until you’ve fully exhausted your other retirement account investing options. Because of their higher annual expenses, annuities generally make sense only if you won’t need the money for 15 or more years.

Selecting retirement account investments

When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You choose what investments you want to hold inside your retirement account shell.

You may invest the money in your IRA or self-employed plan retirement account (SEP-IRAs and so on) in stocks, bonds, mutual funds, and some other common investments, including bank accounts. Mutual funds (offered in most employer-based plans) and exchange-traded funds (ETFs) are ideal choices because they offer diversification and professional management. See Book 5 for more on mutual funds and ETFs.

Chapter 2

Minimizing Your Taxes When Investing

IN THIS CHAPTER

Seeing how investments are taxed

Considering tax issues when selling an investment

You should pay attention to tax issues when making investing decisions. Actually, let’s rephrase that. Like plenty of other folks, you could ignore or pay half attention to taxes on your investments. Unless you enjoy paying more taxes, however, you should understand and consider tax ramifications when choosing and managing your investments over the years.

Tax considerations alone shouldn’t dictate how and where you invest your money. You should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the investment.

This chapter explains how the different components of investment returns are taxed. You find proven, up-to-date strategies to minimize your investment taxes and maximize your returns. Finally, you discover tax considerations when selling an investment.

Understanding Investment Taxes

When you invest outside tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation. (Distributions are taxed in the year that they are paid out; appreciation is taxed only when you sell an investment at a profit.) So the nonretirement-account investments that make sense for you depend (at least partly) on your tax situation.

Tracking taxation of investment distributions

The distributions that various investments pay out and the profits that you may make are often taxable, but in some cases, they’re not. It’s important to remember that it’s not what you make before taxes (pretax) on an investment that matters, but what you get to keep after taxes.

Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds, which are issued by the U.S. federal government, pay interest that’s state-tax-free but federally taxable.

Municipal bonds, which state and local governments issue, pay interest that’s federally tax-free and also state-tax-free to residents in the state where the bond is issued. (For more on bonds, see Book 4.)

Taxation on your capital gains, which is the profit (sales price minus purchase price) on an investment, is computed under a unique federal taxation system. Investments held and then sold in less than one year at a profit generate what is called short-term capital

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