So, you're sitting at your desk, pocket calculator in hand, tax forms in front of you, and salivating at the prospect of fat wads of cash falling into your lap thanks to last year's much-ballyhooed tax cut.
We've got bad news for you, Fool. You've already spent that money.
Remember that surprise U.S. Treasury check you got a few months back? Up to $300 for most single taxpayers, $600 for couples? The one you squandered on fishing gear or home repairs or whatever impulsive trifle happened to strike your fancy at the time?
Yep. That was your tax break. Or most of it, anyway. You'll see a bit more this year in the form of a half-percent drop in your marginal tax rate. But at just five bucks per thousand dollars of taxable income, we're talking chump change, unless your income is well above six figures already. And even while tax rates are scheduled to decline even farther in the years ahead, for most of us the difference will amount to only hundreds of dollars per year. That's nothing to sneeze at, of course, but not enough to get you thinking about changing your zip code to 90210 any time soon, either.
As it happens, those who are looking for relief in the tax rate tables are searching in the wrong place. Far more significant to the average taxpayer -- and with potentially huge payoffs for those who know how to take advantage of the rules that will soon be in effect -- are the new, higher contribution limits on IRAs and other tax sheltered accounts. These new limits are breathtaking in their potential to help you set aside thousands of dollars of tax-protected funds for your retirement.
Consider, for example, the new limits for both traditional and Roth IRAs, which jump to $3000 this year, up from the $2000 limit that has been in effect for 20 years. Those limits are scheduled to rise again, to $4000 annually in 2005, and then to $5000 in 2008. Modest as those numbers seem, over the course of the decades, the long-term reach of those new limits is profound.
Suppose you've got 30 years before retirement, and you're investing in an index fund, which has produced an average historic return of 11% per year. Imagine two scenarios -- in one, you're contributing the same $2000 per year that has been America's habit for nearly a generation. In the other scenario, beginning today, you'll be contributing the maximum limits that are now allowed under the new tax rules.
In the first scenario, after 30 years, you've collected over $440,000 for your retirement -- quite impressive for a lifetime of regular savings. But in the second instance, with the same annual return, you've accumulated a full $935,000 in the same period of the time -- more than twice as much as before, and nearly half a million dollars more than you would have collected under the old limits.
If you're having trouble identifying it, the word that is spontaneously forming on your lips just now is, "yowza!"
How much you'll be able to shelter from taxes over the course of these years will depend on a great many factors, including the actual amount of your contributions, the long-term return you actually achieve, and how much time you have between now and the date you begin making withdrawals. However, the possibilities for new savings that are implied by these new rules should be compelling. On top of that, there are also new contribution limits for 401(k)s, 403(b)s, and other long-term savings plans, and those limits are rising by amounts that are even greater than those outlined above.
In aggregate, the full impact of all these new rate limits can be staggering. But to take full advantage of them, you will need to understand their long-term implications, and to take steps to make them work for you. The biggest problem with saving money, aside from earning it in the first place, is developing the discipline and habits to keep it and help it grow. The new tax rules will make that job easier for many of us -- especially those of us who are aware of the power of steady, regular investing over the long term. The funds you might be able to shelter from taxes over the course of your lifetime could now quite realistically reach into the millions.
A few of the other rate changes that are now scheduled:
- Contribution limits to 401(k) and 403(b) plans are rising, in increments, from $10,500 in 2001 to $15,000 in 2006.
- SIMPLE plan (that's Savings Incentive Match Plan for Employees IRA, for small businesses) contribution limits will also rise incrementally, from $6500 in 2001 to $10,000 in 2005.
- Taxpayers above the age of 50 are now eligible to contribute even more to their IRA and 401(k) accounts, according to new "catch-up" provisions that allow older Americans to make up for lost time.
- Lower-income individuals will be eligible for tax credits if they put aside some money for retirement savings.
All taxpayers are different, and it will require some research on your part to make sure that you are taking full advantage of the new tax rules -- and yes, it can be very complicated. Roy Lewis (TMF Taxes) can get you started in your research as he outlined the changes in contribution limits in February.
Those of you who are TMF Money Advisor members will have a special advantage in this research, because the DirectAdvice online financial planning tool has been updated to account for all the new tax rates and contribution levels. All you have to do is run your plan again and all your information will be updated. An hour or two spent playing with the possibilities could be enormously inspiring to you, so take the time to have some fun inventing your new future.
As usual, the responsibility rests on your shoulders. If you have tax questions check out TMF Money Advisor. Join by March 27 and you'll receive free enrollment in The Motley Fool Panning for Gold Online Seminar.
For more help with your taxes right now, start here.
Jerry Thomas sure could use a half a million bucks right about now, and if you've got an offer, he's willing to talk. The Motley Fool has a disclosure policy.