Tax Deductions Are Not as Valuable as in the Past

Tax Deductions Are Not as Valuable as in the Past
Suze Orman

The 2003 federal tax bill pushed income tax rates to their lowest level in decades. That's great, but it means that the value of your upfront deductions is less valuable now than it was in past years. Okay that is no big deal, for overall you are paying less. But let's also think long-term.Given our federal budget problems, our Social Security fund issues and lord knows what else, do you think our government can afford to keep rates this low forever? If you do, please email me right now. I have a bridge to sell you. Seriously, rates in my opinion are eventually going to have to rise. I am not saying that they are going to go up in the next few years, but then you most likely don't plan to take money out of your retirement plans in the next few years either. So it doesn't really matter in that regards does it? However in twenty or thirty years from now when you just might be needing to withdraw your retirement savings, higher tax brackets are a distinct possibility. And if that happens, you best be prepared. For all that money that you are now putting in your tax-deferred retirement accounts may not be worth as much as you think when you go to take it out. Remember because you have funded those retirement accounts with pre-tax dollars, when you go to take them out you will have to pay taxes on that money at whatever tax brackets are in effect at the time. So it is not how much you have in those accounts that matters, it is how much of that money you will actually get to keep and use in the long run. So does it make sense to take these low tax write-offs today to possibly pay a lot more when you go to take that money out? Maybe yes maybe no, but I just don't think so.

Let’s look at your alternatives keeping this possibility in mind.
When to invest in a 401(k) and when not to!

Don’t worry I am not about to trash 401(k)s, but here’s another idea that I really want you to take action on. Your employer retirement plan at work (401(k) or 403(b)) is probably where most of you save your money for your retirement. However in some cases it may prove not to be the best alternative for your retirement dollars for reasons that I just mentioned above.

Here’s a great strategy to get the most out of your retirement plans: If your employer offers a company match for your 401(k) plan, please please please invest all you can to get the maximum employer match. This is the system where for every dollar you contribute to your retirement plan, your employer also kicks in a contribution. Typically 50 cents or so for each dollar of yours. Many employers cut off their contribution at a max of $1,500 or so. That employer match is literally free money you cannot afford to pass up. But after you max out on the match, or if your employer does not match at all, I want you to think about (if you qualify; see below) contributing to a Roth IRA rather than your employer sponsored plan.

The Best and Easiest Tax Moves to save for your future

Let’s cut to the chase: If you are single and your adjusted gross income (AGI) is below $95,000 or you are married and file a joint return and your combined AGI is below $150,000 I want you to consider investing the yearly maximum of $3,000( $3,500 if you are 50 or over) in a Roth IRA. Right now. Don’t give me any excuses. A Roth is simply the best tax investment out there, yet I am amazed at how many eligible folks just let it pass on by.

Here’s the deal:

While a Roth doesn’t give you any upfront tax relief its benefits so outweigh any other retirement account out there, it is not even funny. That’s because it is the only retirement vehicle where you do not pay any tax on your withdrawals. With a traditional IRA, a 401(k) and a 403(b) you are going to be stuck paying tax—at your ordinary income tax rate when you withdraw any money. And with all of those retirement accounts you will also get hit with a 10 percent penalty if you need to make any withdrawals in whatever amounts you want before you are 59.5. The neat thing about the Roth is that you can withdraw your contributions at any time regardless of your age with no tax and no penalty. Now be careful here: it’s your contributions or the amount of money that you actually put in, that you can get a hold of at any time. You can’t touch your gains for at least five years and until you are 59.5; otherwise you’ll get hit with the penalty.

But do you understand what a great deal this is my friends? When you start making the withdrawals in retirement everything is tax-free. Stick with me here, for you need to get this. Let’s say you are 35 and you put in $3,000 a year for three years for a total of $9,000. That $9,000 is the amount you originally contributed. You are now 38 and your $9,000 has grown to be worth $10,000. And something happens and you need some money. In your Roth you can withdraw up to the $9,000 in contributions without any taxes or penalties from the government. It is the $1,000 of growth that has to stay in the Roth for at least five years and until you are 59.5. And once you reach that age and start pulling the money out, you will owe zero tax. No income tax, no capital gains tax. Nada. As for all the other retirement accounts? Well, you short-sighted sillies who love the upfront deduction, when you make withdrawals you are going to pay tax. Because on all those other retirement accounts (401(k) and 403(b)) withdrawals are taxed at your regular income tax rate. And who knows how high those rates will be years from now.

Another great benefit of Roth’s is that unlike other retirement accounts, you do not have to start making withdrawals when you turn 70.5. And when you die, your heirs can take possession of the Roth, and when they withdraw the money they will not be required to pay any tax as long as the owner had owned the Roth for at least five years. That’s not how it works with traditional IRAs, 401(k)s and 403(b)s, Sep IRAs, Simples or any other retirement account.

Your Action Plan

If you have the money to fund both your Roth IRA to the max and a 401(k) plan to the max, that’s great. I don’t have a problem with that, but if you do not have that kind of cash lying around, I want you to suspend your 401(k) deductions once you max out on the employer match. Then take the same amount you would have been investing in the 401(k) and instead invest it in a Roth IRA account you open up at a discount brokerage such as Ameritrade or mutual fund company such as Vanguard. Then make sure you sign up for the 401(k) again in time to be eligible for the next year’s employer match. Again if you have the flexibility to do both, go for it. But if money is tight you need to be tax smart: the 401(k) up to the employers match, and then the Roth.

Quick Investment Tip: In a 401(k) plan you are limited to only the investment choices that are offered to you in that plan by your employer, which usually consists of their stock and maybe a few mutual funds. In a Roth IRA opened at a discount brokerage firm the whole world of investments is opened up to you. You can buy individual bonds, rather than just bond funds. You can also buy Exchange Traded Funds (ETFs) rather than mutual funds. That can be big. You can also buy Certificates of Deposit (CDs), Real Estate Investment Trusts (REITs), and Treasury Bills, Notes and Bonds. That flexibility in choice is a big advantage. And don’t worry if it all sounds confusing. Over the course of the year I will tell you everything you need to know about all these investments. But for now back to TAXES.

Don't Sink Your Own Tax Boat

Okay, so many of you are reading this and saying, “Suze I know about Roth IRAs and I am just about to make a contribution for last year into my account so what are you telling me that I do not know?” Keep reading for if you are about to make a contribution this year for last year’s IRA, boy are you missing the boat.

There are literally millions of tax filers who will make their 2003 IRA contributions in the coming weeks, and that’s perfectly kosher to do so since you have until April 15th of 2004 to make your 2003 contributions. But by waiting so long you are literally wasting tens of thousands of dollars by doing it this way. If you start making your IRA contribution early in the year (in this example, if you had started in January 2003) rather than waiting to the last minute, you are going to give your money all the more time to compound. If you were to invest $3,000 in January and you did that every January for the next 30 years while earning an average return of 8 percent a year, you would have about $340,000 at the end of the 30 years. However, if you invested the same $3,000 a year, but you did it at the end of the year, your investment would be worth $312,000. Now think about this, you invested the exact same amount of money, you earned the exact same 8 percent, but by investing in January of each year rather than December, you have $28,000 more. That is a lot of money!

Now even if you don’t have the $3,000 handy at the beginning of each year I want you to open a Roth IRA with an automatic investing plan; you can have $250 a month deducted from your savings or checking account and invested in your Roth in a good no load mutual fund. By the way if you invested $250 every month starting in January rather than waiting till the end of the year in December and investing all $3,000 at once, over 30 years at an 8% average rate of return you would have $12,461 more. You can’t pass this tip up - just start now.