The calendar's about to turn the page, and April 15 will be here before you know it. As we enter crunch time for getting your tax return prepared, you're running out of time to take advantage of the easiest way to reduce your tax bill: opening an IRA.
Why you must act now
In a pinch, you can always get an extension on filing your taxes. But you can't extend the April 15 deadline to contribute to an IRA covering the 2012 tax year.
Opening an IRA has both short-term and long-term benefits. With a traditional IRA, many taxpayers can reap immediate tax savings by deducting the amount they contribute from their gross income, up to $5,000 for those younger than age 50 and $6,000 for those 50 or older. That in turn reduces the amount of tax owed. For instance, if you contribute $5,000 to an IRA and you're in the 25% tax bracket, then you'll save $1,250 off the tax bill you'll owe in April.
In addition to the federal tax benefits of opening an IRA, many states that impose income taxes also give you tax benefits for your IRA contribution. That can add even more tax savings.
The real payoff of IRAs
As valuable as that upfront tax deduction is, it pales in comparison with the long-term value of having money in an IRA. One key benefit of IRAs is that as long as you keep your assets within the account, any taxable income -- whether it be interest, dividends, or capital gains from sales of investments -- is tax-deferred.
That has two main consequences, both of which are favorable. You don't have to pay tax on the income that your IRA investments generate, so you can focus more on choosing the investments with the best prospects for strong returns without worrying about their potential tax impact. But almost as valuable as the tax savings is the fact that you don't have to track all that income within your IRA. Burdensome requirements like reporting gains and losses every time you sell an investment, as well as reporting every interest, dividend, and other income payment on an annual basis are unnecessary within an IRA except in some very rare cases.
Quantifying the benefits of tax deferral is harder than calculating the immediate tax savings on an IRA contribution. But by making some estimates, you can get a sense of just how much additional tax you'll avoid on an annual basis by having your investments within an IRA.
For instance, dividend-producing investments have gotten popular because of their relatively high income in a low-return environment. For the following widely held dividend investments, here's a look at the potential savings from holding shares in an IRA:
- Mortgage REITs Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) have turned low rates into lucrative dividend payouts by using leverage to magnify the returns on the mortgage-backed securities they own. American Capital Agency yields more than 15%, producing more than $750 in income on a $5,000 investment. Because that dividend gets taxed at ordinary-income rates, holding shares in an IRA let you defer paying as much as $300 every year. For Annaly, $550 in income produces savings of as much as $220 annually.
- Business development companies Apollo Investment (NASDAQ:AINV) and Prospect Capital (NASDAQ:PSEC) obtain tax benefits by investing in privately held companies, providing debt and equity financing to help smaller companies get the financing they need to grow. Like REITs, BDCs are required to distribute the bulk of their income to shareholders every year, producing yields in Apollo's case of more than 9% and in Prospect's case of about 12%. Those yields correspond to income of $450 and $600, respectively, on a $5,000 investment, and IRA treatment could produce savings of as much as $180 to $240 annually.
These high-yielding investments are particularly good examples of how you can benefit from an IRA. But even lower-yielding alternatives earn savings from tax deferral.
Don't miss out!
With just two weeks to go to save hundreds on your tax bill, don't wait any longer to open an IRA for the 2012 tax year. It could prove to be the best move you'll make all year with your finances.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter: @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.