Protect yourself from Uncle Sam!

Uncle Sam wants his money, and who can blame him? The government tells you that some of your money actually belongs to them. However they are willing to give you a break here or there if you are smart enough to utilize these benefits. You can defer taxes, reduce taxes, and even avoid some taxes…and in the long run this will save you literally thousands and thousands of dollars for your retirement. Last week I talked about qualified accounts being one of the 5 “buckets” of money; qualified accounts are simply accounts that hold certain tax-incentives in them, such as 401k’s and IRAs. Often retirement accounts will be sponsored by your employer, but accounts can be opened individually as well. When it comes to retirement accounts, or “qualified” accounts there are literally thousands of rules and regulations, but to keep things simple there is really only two types of accounts you need to know and understand. One is the tax-deductible account, these accounts allow you to put away money before it is taxed as income, and the other is a tax-free account, which is simply taxed up-front to avoid the taxes down the road. To demonstrate how effective this can be let us look at an example:

Joe makes $100,000 a year and wants to put away 5% for retirement. Joe can utilize his 401k at work, or an individual retirement account (IRA). In doing so Joe is able to deduct his 5% savings from his gross income. This means that not only is he putting away $5,000 but he is being taxed on only $95,000 rather than the full $100,000. How does this translate into savings? Well if Joe has a 20% income tax liability he would save $1,000. Think of all the things you can do with an extra $1,000!

Income	$100,000		Income	$100,000
Deduction	$5,000	Vs.	Taxable Income	$100,000
Taxable Income	$95,000		Tax Rate	20%
Tax Rate	20%		Taxes Paid	$20,000
Taxes Paid	$19,000

Extra benefits of qualified plans are that these accounts grow tax-deferred, which means that any capital gains that are experienced aren’t taxed until they are withdrawn. This is a huge benefit, imagine a snowball rolling down a hill, as it gets bigger it rolls faster, and as it rolls faster it gets bigger. (That is my analogy to compounding interest) Now, if you were to constantly take out little chucks of snow every couple of feet or so, you would be slowing down the process…this is what taxes do to a portfolio and that is why it is important to protect yourself from taxes.

Another popular qualified account is the Roth IRA or Roth 401k. These differ from the previously mentioned accounts in the fact that these are post-tax savings rather than pre-tax savings. Instead of deducting your savings and being taxed down the road (saving extra money today) you can pay the taxes now, and not be taxed on any withdrawals. Take a look at the photo below to help understand how it works.

As always if you have any questions let me know!

Take advantage of your buckets...don't end up like this guy in the photo!