With the stock market finally making a comeback from its 2009 crash, more and more investors are once again becoming increasingly active in the stock market. Admittedly, every investor is looking for the best possible return on their investment. Unfortunately, they do not always think about the tax side of their actions until it’s too late. If you are unaware, taxes can eat away at your returns and leave you with much less than you were expecting. Of course it is important to have a long-term plan, because saving taxes now is not always the number one focus. To illustrate this I’m going to give you an example:
Jenny, a single 30 year-old marketing major has an adjusted gross income (AGI) of $50,000 a year ($46,500 from wages and $3,500 from capital gains). Her employer offers a Roth 401k plan to which she makes yearly contributions of $5,000. A Roth is a plan that uses already taxed dollars to make the contribution. Within the past few years she has been getting more and more into investing. At this time, she is not concerned with the tax consequences of her investing because she assumes there’s nothing she can do to save in that area.
While I applaud Jenny’s interest in investing, there are more things for her to consider from a tax standpoint. Let’s look at the numbers.
Scenario #1 | |
AGI: | $50,000 |
Less Standard Deduction: | $5,950 |
Less Personal Exemption: | $3,800 |
Total Taxable Income: | $40,250 |
Tax Due: | $5,749 |
Next, let’s assume that Jenny changed one thing: instead of making a contribution to a Roth 401K Jenny opts for a Traditional 401k, one that uses pre-tax dollars for the contribution. Let’s discuss how her income tax due changes!
Scenario #2 | |
AGI: | $45,000 |
Less Standard Deduction: | $5,950 |
Less Personal Exemption: | $3,800 |
Total Taxable Income: | $35,250 |
Tax Due: | $4,331 |
Tax Savings: | $1,418 |
Because she has now opted for a tax-deferred retirement account she has effectively “pushed” herself into the 15% tax bracket. As a result of this, portions or her income are no longer being taxed at the 25% tax bracket and she is fully taking advantage of the more favorable capital gains tax rates (she is now paying a 0% capital gains tax!)
It can be very costly for investors, or anybody, not to take taxes into consideration when making decisions. When it comes to taxes, communication is key. Always keep your accountant informed of changes in your income situation throughout the year. Keep in mind also that I am only looking at the standpoint of saving taxes today. One benefit of a Roth 401k is that future retirement distributions are not taxable since you never received a deduction, while distributions from a traditional 401k are taxable.
By: Courtney Elgin, CPA