President Joe Biden's tax plan could come with a mega increase in capital gains taxes, driving the top rate from 20% to 39.6% for long-term investors. If you add on the 3.8% tax on investment income, the highest earners could be looking at tax rates as high as 43.4%.
These potential tax hikes make the Roth IRA look even more attractive. If you've been putting off your tax planning strategy, this is the time to dive in before your window of opportunity for the most coveted opportunities closes.
Let's jump into Biden's tax plan and how maxing out your Roth IRA could be your saving grace.
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Biden's plan could transform capital gains taxes
Biden hasn't been shy about his desire to raise taxes for the wealthiest Americans. He's on a mission to fund social programs and needs the money to make it happen. That's why Biden is tapping into a section of the tax code that hasn't been touched in years: capital gains.
Capital gains taxes are incurred when you sell stocks at a higher price than you paid for them. Let's say you bought stocks for $13,000 and sold them for $20,000. That's a profit of $7,000. Your earnings would be subject to short-term or long-term capital gains taxes.
While current short-term capital gains tax rates aren't anything to brag about, the long-term capital gains rates have been too good to pass up. Investors who have held stocks for over a year before selling them have gained access to the coveted 0%, 15%, and 20% tax bracket. But this could all go away if Biden's plans to increase capital gains taxes go through. In fact, investors could potentially see taxes on long-term profits in the stock market rise higher than taxes currently paid on wage income.
Let the Roth IRA work in your favor
Nothing has been etched in stone yet, but it's best to plan ahead instead of being caught off guard later. If you qualify, a Roth IRA could be your secret weapon against future tax hikes.
A Roth IRA allows you to take care of your tax tab up front and then invest in assets that can grow your portfolio. When you're eligible to withdraw funds at 59 1/2 and have met the requirements of the five-year rule, you can take the entire pot of money that has grown in your account 100% tax-free. You won't even have to think about capital gains taxes (or any future taxes) when you contribute to a Roth IRA.
To qualify, you must have earned income for the year and your income must fall below the limits to make a direct contribution. A Roth IRA works best when you think you can get a better deal on your tax bill now versus later. If you expect your income to significantly increase later or you think that tax rates will skyrocket, funding a Roth IRA makes sense right now.
Leverage the Roth IRA and contribute the max
It's tempting to run straight to a taxable brokerage account to start your investing journey beyond an employer-sponsored retirement plan.
But you should think twice about making taxable brokerage accounts your one and only option. Every penny you earn could be taxed based on your ordinary income tax rate or higher capital gains rates. News is spreading that a tax hike could impact those with $1 million in annual income. With a Roth IRA, you could make $2 million in the future and that wouldn't impact the taxes on any qualified withdrawals you make.
Let's cut to the chase and discuss what you can do now to use the Roth IRA to its full potential. For starters, contribute as much as you can. The maximum contribution for most taxpayers under 50 is $6,000 for 2021. The more you save in a Roth IRA, the better the chances you have of generating more tax-free income during retirement. If you contributed $6,000 to a Roth IRA every year and earned a 7% average annual return, you would be well on your way to tapping into a million-dollar tax-free Roth IRA within 40 years.
Gain access to tax-free income
By using a Roth IRA, you pay taxes now and eliminate the guesswork later. Therefore, if your income increases during retirement, you already know that you have secured a source of cash that's exempt from future tax increases.
No one knows what future tax rates will be. Biden's tax plan could mean a makeover for the entire structure of capital gains taxes that investors have relied on. When you max out your Roth IRA now, you can sleep better knowing that you've just tapped into an extra stream of tax-free income for life.
