Tax season is almost over, and there are only a few things left that you can do to affect what you owe for 2012. But looking forward to the 2013 tax year and beyond, adding a Roth IRA to your arsenal of retirement investing tools could save you a ton in taxes in the long run.
The Best Way to Pay Zero Tax
Ever since they first became available to retirement savers in 1998, Roth IRAs have offered a unique opportunity. In a departure from past methods of saving for retirement that involved deferring taxable income until future years, Roth IRAs changed the timing of the tax break they offered. Rather than giving you an upfront tax deduction that can lead to tax savings right now, Roths give you all their benefits on the back end: Assets within an account grow free of tax, and the withdrawals you take at retirement are eligible for tax-free treatment as well.
With tax rates on the increase, the value of being able to shelter income from tax has gone up quite a bit this year. Moreover, with current proposals aimed at raising taxes even further in the years to come, getting money into a Roth IRA now -- while that opportunity is still available -- could be even more valuable in the future.
Just How Much Is a Roth Worth?
Skeptics might argue that the maximum contributions of $5,000 for the 2012 tax year and $5,500 for 2013 -- plus an extra $1,000 if you're 50 or older -- don't give you enough in tax savings to be worth the effort. But depending on how successful an investor you are, getting the tax-free growth that Roth IRAs provide can be worth a lot more than you'd expect.
As an example, turn back the clock to 1998, the first year Roth IRA contributions were available. Back then, you were allowed to contribute only $2,000 per year to a Roth IRA. Since that time, an investment in an S&P 500-tracking index fund has produced returns of about 5 percent per year, which would have taken your initial $2,000 investment up to almost $4,250. With maximum tax rates on capital gains and dividends of 20 percent, a Roth could have saved you as much as $450 in taxes.
That's nice, but it's far from extraordinary. Yet consider this: if you were fortunate enough to choose some of the top-performing stocks in the market for your Roth, the impact would have been much more substantial. The numbers will shock you:
Total Return Since 1998
Potential Tax Savings on $2,000 Initial Investment
Gilead Sciences (GILD)
Monster Beverage (MNST)
Source: S&P Capital IQ. Assumes current maximum long-term capital gains rate of 20%.
Clearly, these results are extraordinary. And, sure, maybe you're not a star stock picker. But the examples above clearly illustrate the full power of the Roth IRA in action, as the tax-free retirement vehicle was custom-made for maximum-growth stocks.
Finding those successful stocks is certainly challenging, but when you do, having them within a Roth IRA unlocks their full profit-producing potential.
Ride Your Roth to Riches
Most people are eligible to contribute to a Roth IRA, with income limits putting restrictions only on certain high-income taxpayers. Moreover, even if you can't contribute directly to a Roth, you may be able to convert an existing IRA or 401(k) into a Roth account.
Either way, using a Roth IRA makes sense for many taxpayers, especially those for whom current tax deductions from traditional IRAs are either unavailable or of minimal value. The better the investments you find, the more they'll pay off for you in tax savings within a Roth.
Motley Fool contributor Dan Caplinger owns shares of Apple. The Motley Fool recommends Amazon.com, Apple, Gilead Sciences, and Monster Beverage. The Motley Fool owns shares of Amazon.com, Apple, and Monster Beverage.