The 1 Step Guide to Paying Less Taxes & Saving for Retirement

Taxes suck. I almost cried when I got my first paycheck a few months ago. Not a happy cry but the kind of cry you hear when you see how much of your hard-earned cash goes straight to Uncle Sam. I felt betrayed and dispirited. How did no one ever teach me or even warn me about these things?

Well today, I’m here to explain how you can save tens of thousands if not hundreds of thousands in taxes when you’re saving for retirement. To start off with, let’s make a distinction between the taxes you pay on your salary or the money you make from your job and the taxes you pay on your investments. Now depending on which you think will be higher, there are two options that allow you to no longer be required to pay taxes when building up those retirement savings. Both of these options are different types of Individual Retirement Accounts(IRA’s). These IRAs are something that you should be taking advantage of and are special types of accounts you can open up at pretty much any brokerage these days.

The brokerages I personally use are Fidelity, Webull, and Robinhood. Out of these, I chose Fidelity to open up my IRA as it is a more traditional brokerage and because of the quality and quantity of Fidelity’s mutual funds.

These IRAs are essentially a life hack that no one tells you about. Depending on which type of IRA you choose, you could skip out on paying income taxes or investment taxes on everything you contribute to these accounts.

What are IRAs?

The first option you have is to create a Traditional IRA. This allows everything you contribute to investing in this account to be qualified as pre-tax so you won’t have to pay taxes on anything you contribute(contributions will not count towards your taxable income for the year). Unfortunately, this type of IRA will still require you to pay investment taxes such as capital gains or dividend taxes in the future.

If you’re currently at or around the peak of your career and you’re making more money than you expect to make in retirement then a Traditional IRA will make the most sense as you will be in a lower tax bracket in the future. This means that everything you contribute will no longer be included in your current taxable income. This might also help drop you to a lower tax bracket.

The second option is called a Roth IRA and is essentially the opposite of the Traditional. You will still need to pay all the taxes on your contributions upfront or in other words, your contributions will still be part of your taxable income. The bright side is that in the future, everything in your Roth IRA is no longer subject to taxes such as capital gains, etc.

This option is much better for people just starting out in their careers before their income starts to grow. For example, a recent college graduate would be the ideal candidate to open a Roth IRA as they most likely have a smaller starting salary and expect their income to grow as they advance in their careers. This means that currently they will be in a lower income bracket and would rather pay the taxes up front now in order to skip out on the future taxes that they would otherwise have to pay.

Based on your situation, you’ll have to decide if it might be better to have either a Traditional or Roth IRA. For those that don’t want to choose or want to keep their options open, it is also possible to have both types of accounts open at once.

So now if you’re thinking that this is just too good to be true or that this is some kind of scam, you’re not entirely wrong. The people at the IRS wouldn’t be happy if everyone just stopped paying taxes so they created an annual contribution limit for IRA’s. First and foremost, you need to have at least some sort of taxable income in order to start contributing. As of 2020, you are only able to contribute a combined $6,000($7,000 if you are 50 or older) total per year to either a Traditional or Roth IRA. These contribution limits change slightly over time to account for inflation so it is good to always check to make sure you are under the allowed contribution limits.

Another restriction IRA’s are subject to is that they were created with the intent of being vehicles to encourage retirement savings. Due to this, you are not able to withdraw anything penalty-free from these accounts until age 59 ½ and you must begin making withdrawals by age 72. If withdrawn before age 59 ½, a 10% penalty in addition to income taxes will be incurred. Fortunately, there are a few exceptions in which you may still be able to withdraw from your IRA penalty-free.

These exceptions are:

• First Time Home Purchase — There is a $ 10,000-lifetime withdrawal limit and funds must be used within 120 days.
• Educational expenses — Some types of withdrawals for yourself or immediate family members are penalty-free if used for educational expenses.
• Death or Disability — In the case you pass away, your beneficiaries will not have withdrawal penalties. If you’re disabled you may also withdraw without penalties.
• Medical Expenses — For Traditional IRA’s you may use funds to pay medical expenses that do not exceed 7.5% of your adjusted gross income and for Roth IRA’s you may only use funds to pay medical expenses if you are unemployed.
• Birth or Adoption Expenses — There is a $5,000 withdrawal limit to be used penalty-free for birth or adoption expenses.
• Periodic Payments — There is no penalty if you set up a regular distribution schedule of withdrawals.

In America, the average savings rate was only 7.6% in 2019. These IRAs were created to be used as tools to help people save for retirement. To open up your own today you can most likely just use your current brokerage or find any of the various ones out there such as Fidelity or Vanguard. Then all that’s left is to create an application to open either a Traditional or Roth IRA and start contributing.

I just graduated from college in February 2020 but I’ve had a Roth IRA since 2018. Start saving and start saving early. Don’t miss out on these tax benefits as they will compound over time and be worth much more during retirement.

Happy investing!

This article is for informational purposes only not all information will be accurate. This should not be considered Financial or Legal Advice. Consult a financial professional before making any significant financial decisions.