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Don't Defer Paying Tax: Part 1

As an investor, you will no doubt have many people tell you that you should do whatever you can to avoid paying taxes now. The best investment, the common wisdom goes, is one that allows you to take a deduction on your taxes immediately, effectively giving you a partial tax refund as a return on your investment. Once you take advantage of any opportunities for tax deductions, the second-best investment is one that provides tax-free income and growth. If, however, you can't completely avoid taxes, then the third-best thing is to delay having to pay taxes by seeking tax-deferred investments that may have no immediate tax impact at present. Only when you can't find adequate tax-deductible, tax-free, or tax-deferred investments should you surrender to fully taxable investments.

Although this line of thought seems intuitively correct, it does not always give the best results. In a significant number of cases involving common investing choices, the right decision is to go ahead with certain transactions or investments that lead to current taxation. This article discusses a number of cases in which it makes no sense to put off paying taxes.

Students and taxes
Many students work to help pay for college expenses or to earn extra money for incidental expenses. Many of these jobs pay relatively low wages, but over the course of an entire year, these wages can add up to significant amounts. For instance, high school students who work 10 hours each week during the school year and 40 hours per week during the summer earn about $5,000, and that's if they only receive an hourly wage of $5.50. College students who choose to work heavier schedules, or who get higher-paying jobs, can sometimes earn $10,000 or more working part-time.

Because wages from a job constitute earned income, students who work are generally eligible to contribute to an IRA. In 2006, student workers can generally contribute as much as $4,000 of earned income into a traditional IRA and deduct their contribution on their tax return. For students in the 10% tax bracket, making a $4,000 IRA contribution can reduce their tax liability by as much as $400. Even at today's prices, that can buy a lot of pizza.

However, unless they have substantial taxable income from outside sources like investments, most students generally have to pay little or no income tax. Even students who are claimed as dependents by their parents are entitled to a standard deduction that they can apply against as much as $5,150 of earned income. This means that students who earn less than this amount have an effective tax rate of 0%, so the tax deduction saves them nothing. Even students who make more than the amount of the standard deduction generally won't have to pay more than 15% tax on their earned income.

For most students, contributing to a Roth IRA makes far more sense than using a traditional IRA. Although contributing to a Roth IRA does not give students a current tax deduction that may generate an immediate tax refund, the long-term difference is staggering. Consider, for instance, an 18-year-old student who chooses to make just one IRA contribution of $4,000. If the IRA earns a total return of 8% over the course of the next 45 years, then that initial $4,000 will grow to more than $125,000, with no tax liability upon withdrawal. If the student chooses a traditional IRA, he or she may get an extra tax refund of $400 or even possibly $600, but the full $125,000 will be subject to tax when withdrawn from the IRA. While choosing the Roth IRA may cause a bit of pain now, the eventual gain is well worth the cost.

Misusing tax shelters
Some investors have a personal grudge against the IRS. To them, the perfect situation would involve paying absolutely no taxes whatsoever. As a result, these investors often turn to certain types of investments that allow them to deduct current losses and expenses on their income tax returns. Colloquially referred to as tax shelters, these investments usually involve taking current deductions, such as depreciation or depletion, at an accelerated rate that doesn't necessarily reflect the economic reality behind the investment. Some tax shelters are extremely complicated and are used by large corporations; the IRS has gone after large accounting firms, such as KPMG, as well as some alleged users of tax shelters like Wachovia (NYSE: WB  ) and its First Union subsidiary.

The term "tax shelter" has a pejorative connotation that implies abuse by a taxpayer who uses one. From a tax law standpoint, many investments that produce substantial tax deductions for investors are perfectly legal. However, even these legal investments can create a hidden danger for their investors. If a person decides to sell such an investment, a special recapture tax will often apply, essentially forcing the investor to repay the benefits received from previous deductions. The recapture tax rate is determined by current law, so it is possible that the recapture tax may exceed the value of the tax benefit the investor received by taking deductions over the course of owning the investment. In addition, because the entire amount of the recapture tax is often owed in the year in which the investor sells the investment, it can have the effect of concentrating tax liability into a single tax year.

When choosing whether or not to make an investment that generates current tax deductions, it's important for investors to analyze the tax savings of the deductions versus the anticipated future tax cost upon liquidation of the investment. For investors in high tax brackets, the value of the deductions may be sufficiently high to warrant participation. However, even those currently in high tax brackets should consider that tax rates are far lower now than they have been historically. By taking deductions now, investors risk having to pay recapture tax at a time when tax rates may be much higher than they are today. Although this risk exists for investors in all types of investments, the concentrated nature of the recapture tax makes the issue especially important in this case.

So far, this article has examined the impact that choosing different types of savings vehicles can have on your overall investment return and tax liability. The second part of this article turns its attention to decisions faced by retirees who must choose how and when to tap the retirement savings they have accumulated throughout their careers.

Related articles:

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Fool contributor Dan Caplinger doesn't mind paying the tax man -- as long as the checks are small. He doesn't own any of the companies mentioned in this article. The Fool's disclosure policy is always easy to understand.


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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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