|Course 201: Stocks and Taxes|
One easy way to become a more tax-efficient stock investor is to utilize tax-advantaged accounts such as 401(k)s and individual retirement accounts (IRAs). These special accounts allow you to enjoy either tax-deferred or tax-free growth of your investments.
Tax deferral can lead to significant savings over time. Let's assume two investors each start with $10,000 and earn a 10% annual return for 30 years. One has 100% of her gains tax-deferred, while the other realizes the full amount of his capital gains each year and pays a 20% tax on those gains. Under this scenario, the tax-deferred investor ends up with almost $75,000 more at the end than the investor with the taxable gains.
Clearly, it is worthwhile to learn about the types of tax-advantaged accounts available. Below are some of the most popular:
The amount you can contribute to your 401(k) plan is limited to $17,500 in 2013. You also must begin mandatory withdrawals from your 401(k) when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed as ordinary income, and you may be subject to an additional 10% penalty.
However, there are some important limitations to remember. First, you must be age 70 1/2 or younger with earned income to contribute to a traditional IRA. Second, the annual contribution limit is $5,500 in 2013. If you are age 50 or older, you can make additional "catch-up" contributions of $1,000. Finally, like 401(k) plans, you must begin mandatory withdrawals when you reach age 70 1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to an additional 10% penalty.
The Roth IRA has the same annual contribution limits and "catch-up" provisions as a traditional IRA, but you must meet certain income requirements to contribute to a Roth IRA. Generally, single filers with income up to $95,000 and joint filers with income up to $150,000 are eligible to make the full annual contribution to a Roth IRA. Contributions to a Roth IRA can be withdrawn at any time without paying taxes or penalties, but withdrawal of earnings may be subject to income taxation and a 10% early withdrawal penalty if made before you turn 59 1/2.
In addition, the distribution must also be made after a five-tax-year period from the time a conversion or contribution is first made into any Roth IRA. So, if you opened your first Roth IRA and make your first contribution on April 15, 2005, for the 2004 tax year, your five-year period started on Jan. 1, 2004. Assuming you meet the other requirements, distributions made in this case after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.
Next: Tax Planning 101 >>
|Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.|
If you have questions or comments please contact Morningstar.