When folks think about taxes, they’re usually thinking about their tax refund they received (whoop whoop!), or on the flipside, how much they had to pay the IRS (wah, waaaaahhh). In the world of taxes, those two experiences are referring to one area of taxation: Income Tax. Income Taxes are the ones we’re all most familiar with, it’s the primary one assessed on the money we earn, the one we usually think of come April 15th.
But Income Tax is only one type of taxes (and there are about a dozen different types). In the world of finance and full-picture financial planning, there are three types of taxes that most often come up:
- Income Tax
- Capital Gain Tax
- Estate Tax
In today’s blog, we’re going to focus on Income Tax.
With investments, income tax comes up most frequently when we’re thinking about account types that are tax-advantaged, or that have a special tax benefit. Tax-advantaged accounts include Traditional IRAs, Roth IRAs, and 401ks, just to name a few. Let’s use a Traditional IRA as an example.
A Traditional IRA has a maximum limit you can contribute to every year (In 2021, it’s $6,000 or $7,000, depending on how old you are). The amount that you contribute, up to the allowable limit can be deferred from income tax, meaning that you won’t owe any income tax on those contributed IRA dollars in the year that you make the contribution. Think of it like the IRS is giving you a little break, a little bonus for thinking ahead to your future and making a commitment now to save more.
You are not required to begin taking distributions from your IRA account until you are age 72. That means you get to defer a lot of taxes for potentially many decades. Holla!
Of course, there are some trade-offs.
For starters, whether you can contribute $6,000 or $7,000, chances are that won’t be enough to retire on, even if you contribute the maximum amount you are allowed to for 30+ years. You’ll want to find other means of saving additional funds for future needs.
Also, the IRS eventually wants to receive the taxes that you’ve been able to defer on those contributed dollars, and their respective earnings, for so many years. Say you invest $6,000 when you’re 25, and you do so diligently every year until you retire at 65. From age 25-65, The IRS hasn’t collected any tax on those dollars at any time. It hasn’t even collected any tax on the earnings on those contributed dollars. The IRS must wait to collect the tax, all the while twiddling their thumbs, until you begin taking distributions from those contributed dollars. At age 72 and you are legally required to begin taking distributions from your IRAs, that’s when the IRS begins collecting tax.
Of course, the IRS can only collect taxes on your revenue, regardless of how much your retirement accounts are worth. This is where sound financial planning and tax planning can have a huge impact.
Ideally you are retired at this point, so your only sources of revenue are your retirement accounts and social security. Your house is paid off, so your expenses are typically a lot lower. You may find yourself in a better tax bracket than you were in when you were at the peak of your earning potential.
Of course this goes both ways. No mortgage also means no mortgage deductions. You probably don’t have a student loan deduction anymore, or dependent children. The absence of certain types of expenses can take away certain tax benefits and put you into a higher bracket.
The trade-offs aren’t enough of a reason to not save. You’re still able to grow a nest egg, collect earnings, and defer taxes when you’re at a point in your life where there is a greater need to owe less. Deferring income tax is a key strategy of any full-picture financial plan and should be considered and utilized as soon as possible.
In future blogs, we’re going to dig into my favorite type of taxes: Capital Gains. Stay tuned!
