Chances are that if I say the word "taxes," a cluster of not-so-nice words and images will probably come to mind. If that's the case, don't worry -- you're not alone. The majority of Americans dislike having to comb through their financial receipts, bills, and investment accounts from the prior year, and things aren't made any easier knowing that the U.S. tax code is approaching 4 million words in length (that's well over 60 standard-sized novels).
Yet tax time can also be a godsend for 4 in 5 Americans. That's because around 80% of federal taxpayers wind up getting a refund each year. This refund is a method of forced savings for individuals and families who might be working without a budget, or those who struggle to sock money away on a traditional month-to-month or week-to-week basis. It's also fair to say that, with the U.S. economy being heavily consumption-based, this added income into the pockets of the American consumer fuels discretionary spending.
But what if I told you that taking two ridiculously simple steps could net you even more money come tax time. Intrigued? Let's take a closer look.
Doing nothing has never been more profitable
The first thing you can do to pad your pockets is sit back, relax, and let your investments go to work for you over the long term. According to IRS capital gains tax regulations, a short-term holding would be described as an asset, such as a stock or bond, held for one year or less. In comparison, any asset held beyond one year and a day is considered a long-term holding. This difference of a day could mean keeping an additional six-figures over your lifetime -- depending on how much you have invested, of course.
The IRS treats short-term capital gains very simply: you pay the tax rate on gains that's commensurate with your peak ordinary income tax rate. If you recall, we have seven progressive tax brackets that range from a low of 10% to a high of 39.6%. This would mean that if your last earned dollar came in the 28% ordinary income tax bracket, your capital gains tax on any stocks or bonds held for a year or less would be 28%.
On the other hand, long-term capital gains are treated differently for tax purposes. There are currently only three tax brackets: 0%, 15%, and 20%. If your last earned dollar of income places you in the 10% or 15% federal income tax bracket, your long-term capital gains when selling an asset is 0%. For those in the 25%, 28%, 33%, or 35% bracket, your long-term capital gains tax rate is just 15%. Finally, those in the upper echelon of earned income will pay 20% on long-term capital gains. Comparatively, paying 15% or 20% sounds a heck of a lot better than paying 33%, 35%, or 39.6% on your capital gains, and it's a trick that investing moguls like Warren Buffett have used to keep and compound the vast majority of their money. Simply sitting back and holding onto your investments for a long time can save you a lot of money and hassle come tax time.
This retirement tool can save you a ton
The other ridiculously simple tax strategy to employ is opening up and contributing to a Roth IRA.
Americans have a veritable bounty of investment tools to choose from when saving for retirement, but the Roth IRA is arguably the best, as we've explained before. The best attribute of the Roth IRA is that investment gains are completely tax-free for the life of the account, so long as no unqualified withdrawals are made. For instance, if your retirement goal is to attain $1 million, you might owe $150,000-$250,000 (as a rough guess) in taxes on this money over your lifetime if it's removed from a Traditional IRA or 401(k). If your $1 million is within a Roth IRA, you'll get to keep every red cent!
You should be aware that Roth IRAs do include income limitations on who can contribute, although this typically applies only to well-to-do individuals, as well as the five-year rule, which simply means that investment gains within your account need to stay in your account for five years before they can be withdrawn free of taxation.
Two additional advantages of the Roth IRA, compared to, say, the Traditional IRA, is that there's no age limit on contributions, and no minimum required distribution. In plainer terms, this means you remain in full control of when you contribute and withdraw. This is an important point with life expectancies on the rise and Americans looking to stretch their retirement savings for as long as possible. If you want to allow your money to continue growing for two or three decades after you retire, a Roth IRA can make that dream a reality.
Stop giving the federal government more than you need to and consider implementing these incredibly simple strategies today.