This Money Move Makes More Sense Than Ever
Nobody likes to pay taxes, but sooner or later, the IRS will collect what's coming to it. If you can pay less now in order to save more later -- a lot more -- then you shouldn't hesitate.
That's exactly the situation that many people are facing right now. With the very real possibility of much higher tax rates coming in the future, you can't afford not to be prepared to fight against the increase in your tax bill that could be right around the corner.
To fully understand exactly how bad things could get, let's quickly review some of the ways your taxes could rise in the near future.
Starting in 2013, tax rates are set to revert to their levels from more than a decade ago. Unless Congress and the president can agree to extend current cuts, rates on most tax brackets are set to rise between three and five percentage points across the board -- with increases potentially affecting taxpayers in every income bracket.
For investors, preferential rates on dividends will completely go away, while favorable long-term capital gains rates will rise to 20%.
A new 3.8% tax on investment income will affect single taxpayers making more than $200,000 and joint filers with more than $250,000 in income.
Already in 2012, the usual yearly increase in the exemption amount for the alternative minimum tax hasn't yet happened. Without retroactive action by the end of the year, millions more taxpayers could owe AMT on the tax returns they file next April.
In addition, the companies you invest in could suffer from higher taxes as well. Medical-device makers will have to pay an excise tax on sales next year, something that has already led Stryker (NYS: SYK) and Boston Scientific (NYS: BSX) to take steps to implement cost-reduction plans.
Granted, with the presidential election this year, the future of taxation both next year and beyond are very much in doubt. But the key concern you should have is that the way these laws have been set up, it takes affirmative action to avoid a tax increase, and counting on the government to get anything done -- no matter which party wants it to happen -- has been a very dangerous thing to do. Moreover, the proposed budget includes other tax increases, including the elimination of tax preferences for ExxonMobil (NYS: XOM) , Chevron (NYS: CVX) , and other energy companies, as well as higher fees on airlines for security costs and a "financial crisis responsibility fee" on Bank of America (NYS: BAC) and other Wall Street banks that were bailed out four years ago.
With so much uncertainty, it's more appealing than ever to lock in a current tax rate right now and never have to worry about paying tax again. A Roth 401(k) or IRA allows you to do just that.
Roth retirement accounts aren't as popular as their traditional counterparts because they don't give you the upfront deduction that traditional IRAs and 401(k)s do. Because those tax breaks can cut thousands of dollars off your current return, traditional retirement accounts are much more popular.
But the problem with traditional retirement accounts is that eventually, you do have to pay tax on the money. When you withdraw money from a traditional IRA or 401(k) after you retire, you'll pay tax at the then prevailing rate. If that rate's lower than it was when you first put money into the account, then you end up a winner. But if it's higher, you're simply out of luck.
You have a couple of different options to get into a Roth. Opening a Roth IRA is as simple as going to a financial institution and getting it set up, although income limits apply, so you'll want to make sure you qualify. Roth 401(k)s are even easier -- if your employer offers one, then you can just go to your HR department and sign up.
The other way to get into a Roth is to convert a traditional retirement account. No income limits apply to conversions, so you have complete flexibility on when and how much you want to convert.
Whichever way you go, take a good look at a Roth retirement account. Roths aren't for everyone, but they can be the best answer to the threat of higher taxes down the road.
Once you have a Roth, knowing how to invest it is crucial. We've got some stock ideas tailor-made for retirement investing. I invite you to read about three of them in the Motley Fool's special report on long-term investing -- just click here and start reading your free copy right now.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter@DanCaplinger.
At the time this article was published Fool contributor Dan Caplinger does his best to make sense. He doesn't shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America. Motley Fool newsletter services have recommended buying shares of Stryker and Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy still has all the right moves.