If capital gains taxes are causing you anxiety, there's a way to shake off your worries. It's called the Roth IRA and it's the ultimate tax-saving vehicle for eligible investors.
Unlike a traditional IRA, the Roth IRA allows you to pay your tax bill up front in exchange for tax-free income later. On top of that, buying and selling stocks in your account before you retire won't trigger any capital gains taxes. That's a pretty big deal especially if you believe you might be subject to higher taxes later.
Since the Roth IRA is a time-sensitive offer that's based on your income status, here's a quick rundown of what you should know to be eligible to kick capital gains taxes to the curb.
How capital gains taxes work
Let's say you purchased $10,000 worth of shares of your favorite company's stock. And now, your shares are worth $13,000. If you sell all your shares, you would have a $3,000 capital gain that is subject to short-term or long-term capital gains rates.
Anytime you hold an investment for one year or less, you'll pay short-term capital gains tax rates that can be as high as 37%. Essentially, you will pay the same rate as you do on your income from a job. If you want to lower your tax bill, you could hold your stocks for over a year and unlock the 0%, 15%, or 20% long-term capital gains rates.
Although lower tax rates are very appealing, there's another offer that can be even more rewarding: no capital gains taxes. This perk is one of the main reasons investors fall in love with the Roth IRA.
Eliminate future tax concerns
When you contribute money to a Roth IRA, you are funding your account with money you have already paid taxes on. That means you won't have to worry about taxes later if you follow all the rules. Let's say you contribute $100,000 over 20 years and your account grows to $700,000. Once you reach 59 1/2 and have met the five-year rule, you can withdraw all the money in your account 100% tax-free.
This tax-free safety net also works when you are buying and selling stocks in your Roth IRA. If you buy your favorite company's stock and sell it six months later, you won't have to pay capital gains taxes. In other words, you can sell stocks in your Roth IRA anytime you desire and you won't have to report your gains on your tax return. Make sure you don't withdraw your earnings before you're eligible or you'll be subject to taxes and penalties.
Determine your eligibility
Before you dump all your money into a Roth IRA and live happily ever after, you should be aware of the rules.
First, you must have earned income to contribute to a Roth IRA. But if your income exceeds the thresholds, you won't be eligible to make a direct contribution to a Roth IRA.
You can only contribute a maximum of $6,000 to a Roth IRA if you're under 50 and $7,000 if you're 50 or over in 2021. Also, you cannot contribute more than your earned income for the year. If you don't want to contribute anything during the year, you are not required to fund the account.
The Roth IRA income limits and contribution amounts may change every year. If you're interested in the Roth, it's a good idea to do your research now and contribute the maximum amount so that you can take full advantage of the capital gains tax exemption.
Enjoy tax-free rewards later
Although most savers can only contribute up to $6,000 every year into a Roth IRA, that money adds up when you don't have to think about future capital gains taxes. You can allow the power of compounding to take control without any disruptions.
Let's say you're 23 and you contribute $6,000 every year to a Roth IRA. By the time you reach 60, you could achieve millionaire status if your investments are earning a 7% return. At this point, you can sell investments in your Roth IRA and take the earnings without splitting any profits with the IRS. Even if your annual income is $3 million for the year, you still won't have to pay any capital gains taxes when you sell your stocks in your Roth IRA.
Stashing money away in a Roth IRA is something to consider if you expect to climb the income ladder. The more money you can save now, the better chance you'll have of building a massive portfolio of investments that is exempt from capital gains taxes.