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
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.
10 Weird Tax Laws
How a Roth IRA Could Save You $185,180 in Taxes
The Centennial State eliminated the tax exemption for non-essential food items and packaging that can come with your food or beverage purchased at your local eatery or convenience store. Sales and purchases of nonessential food items and packaging provided with purchased food and beverage items are taxable at the state sales and use tax rate of 2.9%.
So while cups are considered essential, cup lids are not and, hence, are taxable. French fry sleeves are not taxable but expect to pay sales tax on napkins and towelettes.
When Halloween comes around, Indiana residents may be better off buying a pre-made costume. Indiana's Department of Revenue decided that sales tax could be applied to labor and design of custom-made costumes due to existing law about "retail unitary transactions." In other words, a combined sale of tangible personal property and services becomes taxable when the services are performed before the transfer of the property.
Under federal statutes, state or local governments can't taxes airlines and airport users. But in Kansas, taxes can be imposed on "any place providing amusement, entertainment or recreation services." The state's Department of Revenue concluded that the sales tax could be applied to tethered hot air balloon rides only.
A sweet tooth in the Bluegrass State can get expensive. Candy that does not contain flour faces a sales tax, while candy with flour is exempt. Hence, residents hankering for chocolate-covered almonds will pay a little more than those buying chocolate covered pretzels.
After an uproar about how non-residents could buy boats and repair parts tax-free if they moved their boats out of state within 30 days of purchase and kept them out, Augusta lawmakers amended the law.
Non-residents have to pay 40% of the sales tax if they brought their boats back into the state or kept them in Maine for more than 30 days. Residents, however, remain out of luck: they must pay the full sales tax on the sticker price of the boat and repair parts.
For many families, a haunted house visit during Halloween is a tradition. But beware: The Empire State requires visitors to pay a sales tax in order to be spooked.
Ask a New Yorker what are the best bagels in the city and you'll get some impassioned answers. Just be careful where you eat it. Once a bagel shop staff slices that bagel, it's considered prepared food even if you don't ask for a schmear of cream cheese and is subject to sales tax. As a result, bagel lovers can end up paying some 8-to 9-cents extra per bagel.
Fashionable Texans are paying more for certain items of clothing these days. Buy a belt and it's tax-free. But shop for a belt buckle and expect to pay a sales tax. Cowboy boots and hiking boots are exempt, but rubber boots and climbing boots are taxable.
Before October 2009, ice cream cakes were taxable only when sold for consumption at the store or ice cream shop. Once the state became a member of Streamlined Sales and Use Tax Agreement, ice cream cakes and bars in which the retailer mixes ice cream and at least one other food item together becomes "prepared food" and is taxed. Yet, if it is made by someone other than the retailer, it's not taxable unless it is considered a prepared food because, for example, it came with utensils or napkins.
In the 1960s Washington added a retail sales tax that would be charged at any business that offers customers the "opportunity" to dance. According to ABC News, many Washington businesses complain of arbitrary enforcement of the statute. The state legislature is considering a repeal.
Proponents of the repeal say enforcement targets medium-sized venues or taverns, and not places like sports stadiums that often host concerts where people dance. Recently, Century Ballroom in Seattle and was hit with $250,000 bill on back taxes for not adhering to the law.