All My Homies Hate Taxes
Retirement Accounts are Tax Loopholes for Regular Folks
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Taxes are the worst, plain and simple. Do you remember getting your first paycheck? My salary was ~$52,000 in my first year with UPS. That’s $1000 a week for the math geniuses out there. When I checked my direct deposit that first Friday morning, I saw $754.52. Where was the other $250?
FICA Tax: $70
FICA Medicare: $22
Federal Tax: $97
State Tax - GA: $58
You don’t just pay taxes on your job though. You pay something called “capital gains” taxes for your investments. So check this out: Work 40 hours this week, pay 25% of your salary in taxes. Now say over one year, you invest $10,000 of your leftover money in the stock market. You make several trades that year, and you kill it. 100% return. Your portfolio is now worth $20,000. Guess what? You’re paying your marginal tax rate on that $10,000 profit. There goes another $2500.
Make money at work —> Pay taxes —> Invest leftover money —> Pay more taxes. Somehow, you are getting taxed on the same money twice.
Now what if I told you there are a couple of legal tax loopholes for everyone. Ways to avoid paying Uncle Sam your hard-earned cash. Enter: IRAs and Roth IRAs.
Billionaires have offshore tax havens and accountants to help lower their tax bases every year. We don’t, but we do have retirement accounts. You are legally allowed to contribute a total of $6000 to individual retirement accounts each year. IRAs and Roth IRAs differ slightly, but both help you pay less taxes. The difference is when and where the taxes help you.
The IRA is the OG retirement account. Here’s how it works. You can deposit up to $6000 in your IRA this year. This $6000 is deducted from your taxable income. If you make $60,000 and contribute $6000 to your IRA this year, your taxable income is now only $54,000. Besides reducing your taxable income, IRAs have another benefit: no capital gains taxes. Earlier I mentioned that you will owe taxes on any profits you made from trading stocks. IRAs are exempt from capital gains taxes. You invest in an S&P 500 index fund and make 10% this year? Tax free. You ape all of your money into AMC and make 1000%? Tax free. IRAs are tight.
So what’s the catch? After all, the government wouldn’t just give you free money. First, you can’t withdraw money from your IRA (without paying a penalty) until you are 59 years old. Second, money withdrawn from an IRA is considered taxable income at that point. Say you have a $500,000 IRA when you are 60. If you withdraw $50,000 a year, that is considered $50,000 of income, and you will be taxed accordingly. You save money on taxes up front, and you don’t pay capital gains taxes. However, you will be taxed on the back end.
A Roth IRA is similar to a regular IRA, but it gives you the reverse tax benefit. Like the IRA, you can contribute $6000 to your Roth this year. (Note that can you contribute $6000 to one or the other, but not both. I accidentally double contributed last year, and it was pretty annoying to straighten out). This $6000 contribution doesn’t lower your taxable income right now, so if you make $60,000 you will still be taxed on a $60,000 salary. You do still get the benefit of no capital gains taxes on your investments though. The biggest benefit of a Roth IRA comes on the tail end: while you still can’t touch the money until you’re 59, all of your withdrawals are tax free. Say you have a $500,000 Roth IRA and you withdraw $50,000 when you’re 60. It’s tax free. While you don’t get that upfront benefit like an IRA, you can grow your money tax free, and withdraw it tax free.
Power of Compounding
“Who cares, it’s only $6000 a year,” is what you are probably thinking. Well let’s do some basic math. Say that you are 22 years old, and you will contribute to a Roth for the next 40 years. $6000 * 40 = a basis of $240,000. But that money isn’t going to stay flat. If you invest, it will grow. Every year, you invest $6000 in an S&P 500 ETF like $SPY. Over the last 100 years, the S&P 500 has averaged ~10% a year returns. If you invest $6000 a year for 40 years and average 10% returns, you will have $2,921,110.87. $6000 a year = three million dollars. Pretty cool, right?
Traditional IRA vs. Roth
Congratulations on being a future multimillionaire. Now do you choose the traditional IRA or Roth? As a general rule, you should use a Roth if you expect your tax rate to be higher later in life than it is right now, and a traditional IRA if you expect your tax rate to be higher now than later. Additionally, if you make more than $140,000 a year, you cannot contribute to a Roth IRA.
The Roth defers your tax benefit until retirement. You may only pay 25% in taxes as a 20-something, but 38% later in life. Use the Roth, and you’ll be rich and tax free. Maybe you’re already a millionaire now, and you expect your withdrawals in retirement to be less than your current salary. Use the regular IRA. 99% of the time, the Roth is a better choice early in your career. Once you’re making the big bucks later on, you will have to use the traditional IRA.
Retirement Accounts: a Trading Cheat Code
95% of people shouldn’t trade individual stocks. It’s volatile, time consuming, and difficult. You might spend years trying to do it before you decide that you just aren’t that good. That being said, if you do want to trade individual stocks, do it in your retirement account.
That probably seems backwards. This is your retirement account. This money is important. You’ll live off of it when you’re old. You shouldn’t make risky investments here, right? Ironically, this is the perfect place to make risky investments. Why? The tax consequences.
If you buy stocks in a regular brokerage account like Robinhood, Etrade, or TD Ameritrade, you will either pay short-term or long-term capital gains taxes. Short-term capital gains occur when you sell a stock in under a year, while long-term gains occur if you sell after a year+. Short-term gains are added to your regular income and taxed at that rate: 25%, 30%, etc. Long-term gains are taxed at a favorable rate, typically around 10-15%. If you make $100,000 actively trading, you might owe $30,000 in taxes. However, if you actively trade your retirement account, you don’t owe a thing.
It seems counterintuitive, but the optimal way to balance long-term investments with actively managed positions is by buying index funds in regular brokerage accounts, and individual stocks in retirement accounts. You will save thousands of dollars over time.
This isn’t a recommendation to actively trade stocks, and realistically you will lose money trying. But since you will probably try it anyway, the least you can do is take advantage of tax-free gains with your Roth.
Hopefully this was a useful overview of the benefits of retirement accounts. I plan on writing one personal finance article a week, so shoot me an email or comment here if there are any topics you would like to hear about!