Do you know how to shelter your investments from taxes? Depending on your income level, taxes may take away huge chunks of your return, so paying attention to taxes can turn decent investments into wildly successful ones. Here’s the simple rule: in the USA Uncle Sam will nearly always get paid at some point. Your goal should be to pay the tax when it’s best for you. Here are two ways to attack sheltering investments from taxes:
- Defer the tax until later. This as easy way for 90% of Americans to shelter their investments. Money goes into a 401k, 403b, or 457 plan pretax (deducted from your income) and you won’t pay tax until you’re in retirement. Dollars are automatically deducted from your paycheck, so it’s simple to get money saved. Some people will tell you that you’ll be in a lower tax bracket in retirement, but don’t get caught trying to guess what the tax code is going to look like down the road. Just remember that when you take money out you’ll pay Uncle Sam at that point. The bad news? Except for a few exceptions you can’t get money out of this until retirement (the IRS website has all the key information you'll need about limits and ages for retirement contributions and withdrawals).
- Find investments that are tax free in the future. Two methods to shelter investments are Roth IRAs and municipal bonds. You have to be careful with both of these. According to the IRS, a Roth IRA is an investment of post-tax money (money from your paycheck that has already been subject to payroll tax). The interest or dividends grow tax free and can’t be withdrawn (except for a few exceptions) until retirement. Roth IRAs can contain a wide variety of investments, including stocks, mutual funds, and others. You’ll choose what investment is best for your situation. Unfortunately we’re not all eligible for a Roth IRA. Limits vary by year, so you should check the IRS website for information on contribution limits. According to publicbonds.org, Municipal bonds are loans to cities or other municipalities. These had a tough year in 2008 and tax revenues are more precarious than previously thought. That’s the bad news. The good news is that when you loan money to a municipality your money usually grows federally tax free and (if in your home state) may grow state tax free. Think of this as a thank you gift for helping a city build hospitals, schools, roads, or other projects. More bad news: the interest rates are usually fairly low and you can lose money if the municipality defaults on the loan. This hadn’t been much of an issue until housing prices fell (the main source of income for many cities). A municipal bond mutual fund may be a good option because it spreads the risk of a city not repaying the loan. Although municipal bonds grow tax free, income from these investments still count when figuring your income subject to social security proceeds.
Those are the easiest ways to shelter, but definitely not the only methods available. When you’re ready for "Tax Sheltering 201" you’ll want to look into annuities, life insurance, tax credit investments, and others. These are far more complicated investment options and have a ton more pitfalls.
Internal Revenue Service http://www.irs.gov/publications/p590/ch02.html#en_US_publink1000230969
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