Investment advice: Accelerate savings via tax breaks

It’s now time to look at saving strategies that reduce taxes, esp. the different types of individual retirement accounts (IRAs). IRAs are our federal government’s encouragement to save for our retirement (and kids/grandkids college costs).  This summary will explore the differences in traditional and Roth IRAs and then overview pension plans. We will look at similar plans to save for college costs for kids and grandchildren and close with Malkiel’s “best” tax strategy

Malkiel’s Rule 4: Stiff Tax Collector

Individual Retirement Accounts (IRA) overview (they come in two basic types – pay attention; as other tax breaks use the same basic approaches).

First, be aware there are three different ways to reduce taxes via these IRAs (each type doing only two of the three benefits):

1)      Reduce taxable income (and typically taxes) when you contribute

2)      Avoid being taxed on the growth in investment value over time (in other investments you have to pay taxes as the investments earn money)

3)      Reduce taxable income (and typically taxes) when you withdraw from your IRAs for retirement.

Here are some things that are applicable to both types:

  • Annual limits for IRA deductions (you can do one or the other or both; but in any case, these limits are for the sum): $ 5,000 if under age 50; $6,000 if over 50;
  • both you and your spouse can contribute this amount if you having earned at least that much
  • this limit is reduced if you earn over a certain amount: $90,000 for married filing jointly.

Traditional IRAs. Here you get benefits 1 & 2 but NOT 3.

1) When you put your money in a Traditional IRA, you reduce your taxable income by that account. The contribution to the IRA is subtracted from your income on line 32 of Form 1040, before computing your adjusted gross income. For example, if you are in a 15% marginal tax bracket as many of us are (i.e. for each additional $1000 of taxable income, you pay an additional $150 in taxes), then you can think of it as the government paying for 15% of the IRA through reduced taxes.  In most states, your taxable income for state purpose is also reduced (in KS, many of us a taxed at a 6% marginal state tax rate).

2) The IRA’s growth in value over time is not taxed.

3) However, when pull the money out of the IRA at retirement, it is reported as income and taxes at that time (currently on line 15b of the Form 1040).

The hitch = you must leave the money in a retirement account until retirement age or suffer 10% penalty.

This is still a significant benefit. As is illustrated in the book, at 8%, your money will grow 3 times as fast with this benefit than not. Even considering taxes at the end, you are way ahead vs saving for retirement without the tax benefit.

Roth IRA – In this case, you get benefits 2 & 3 above but NOT 1.

1) So you do NOT get to deduct the IRA contribution from your taxable income in the year.

2) Your investment grows tax-free

3) You can access your contributions at any time without having to claim it as income and without penalty. To withdraw earnings tax-free (and penalty-free), you will need to be at least 59 ½. But follow these rules and your withdrawals are NOT treated as income as with a traditional IRA [it is reported on your tax filing but it is not taxed].

Which type of IRA is best for you? It depends. There are lots of people willing to help you figure it out. In general, if you have plenty of time until retirement, the Roth is best, esp. if in a lower tax bracket.

Pension plans

Some with employers you can contribute at work to a pension plan (typically called 401k or 403b plans). Even when this is not an option with your employer, you can do it on your own (Keogh or SEP-IRAs). The tax benefits and “hitches” and similar to the traditional IRA above. The advantage of these pension plans is you can contribute greater amounts.

What can you invest in and through whom?

A wide range of investments types: stocks, bonds, mutual funds, CD’s.  He will talk about how to allocate between these choices in Rule 5. There are plenty of places to set these up: banks, securities dealers, insurance companies, mutual funds, etc.  More on this topic later as well (Rule 7 and 9).


1)      Retirement plans where your employer matches your contributions

2)      IRAs and non-matching retirement plans

3)      Roth IRAs (can be above number 2 in some cases)

4)      If you have still more, get some help (he has more advice in his book).

Saving for children/grandchildren’s college with tax advantages

529 plans allow for tax benefits like the Roth IRAs for contributions into funds dedicated for use in college expenses for your children or grandchildren. They have a very liberal in definition of educational expenses (including buying apartments for housing your students or cars as transportation).

Many states provide similar state tax benefits for qualified plans.

I encourage you to NOT put the funds in the names of your children (grandchildren’s) as it may negatively affect financial aid.

Educational Savings Account is another option to explore.

His “Best” tax strategy – Buy your own home. It is a form of forced savings. It has tax advantages as well: interest on your loan and real estate taxes can be deducted [however the tax benefit will only occur to the extent your itemized deductions are greater than the standard deduction you can take: for singles that is $ 5,700 and for a couple this is $ 11,400 in 2010).

He also suggests you avoid over-extending buying a house, i.e. limit your mortgage to 30% of your income.

Next time: Stock, bonds, cash – how much do I put where (asset allocation)?

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see the index page to my full summary.

One thought on “Investment advice: Accelerate savings via tax breaks”

  1. An important advantage of the Roth IRA is that you can withdraw contributions at any time without taxes or penalty. It is only the earnings that must be left until age 59 1/2.

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