The word is out that President Biden plans to give the federal tax on capital gains a makeover. But the results may not be so pretty for stock investors. It could mean a higher tax bill that could eat into an investor's gains accumulated in the stock market.
One of the best defenses against future tax liabilities is a tax-advantaged account like a Roth IRA (individual retirement account). For younger investors, investing in a retirement account may not be as glamorous as putting money in a regular brokerage account. But it can pay dividends in the future — especially when you are protected against unexpected tax hikes.
Here's a look into Biden's tax plan and how the Roth IRA can come in handy.
A preview of how Biden's tax plan could look
Biden has dropped a few hints about his plans to increase taxes for wealthy individuals. Recently, there was news about the president's plans to shift the capital gains tax structure from a top rate of 23.8% to 43.4%. This tax hike could impact those with $1 million in annual income. Nothing has been set in stone yet, but it's best to get ahead of the curve and determine the best strategy for your portfolio.
The way capital gains taxes are set up right now makes it more advantageous to hold stocks over a year and capitalize on the benefits of long-term capital gains. A $7,000 long-term capital gain would be taxed at the 0%, 15%, or 20% tax rate depending on your income and filing status. This is a much better deal than short-term capital gains that are taxed at ordinary income rates. These rates are similar to the money earned from working a job, climbing as high as 37%.
But Biden's plan could present a marginal tax rate of 39.6%. If you add on the 3.8% surtax on investment income paid by high earners, you arrive at the 43.4% top tax rate for capital gains. That could mean a higher tax paid on gains from the stock market than what's currently paid on wage income.
It's a lot to digest but don't fret just yet. There could be a way around these capital gains tax uncertainties if you act now.
Roth IRA to the rescue
Capital gains taxes generally apply to regular brokerage accounts. To avoid dealing with those higher tax rates altogether, you can leverage the power of a Roth IRA.
The Roth IRA allows you to take care of your tax bill upfront and then invest in assets that can jazz up your portfolio. When you're ready to enjoy the fruits of your investments, you can withdraw your money 100% tax-free — just make sure you've checked the box on the account requirements. Basically, you need to be at least 59 1/2 and pass the five-year rule to be eligible for tax-free withdrawals. But there are a few exceptions that allow you to tap into your money before you retire.
A Roth IRA is a hit among investors who expect to be in a higher tax bracket during retirement. Let's say you add funds to your Roth IRA now while your income is under the annual limit. The earnings in your account will be tax-free during retirement. You'll be able to withdraw funds without sharing your earnings with the IRS — even if your income rises to $2 million per year during retirement.
Withdraw funds if needed
There may be hesitation around putting tons of money away in a retirement account because you don't want all your cash locked up forever. That's not something you have to worry about with a Roth IRA.
While there may be penalties for withdrawing funds from an employer-sponsored retirement plan too soon, one of the greatest features of a Roth is that you can always withdraw what you put in. You can dip into your Roth IRA and withdraw your contributions tax and penalty-free. Plus, there are no required minimum distributions when you're in your 70s. Therefore, you can leave your money in your account as long as you like and transfer the benefits to your heirs tax-free as long as the rules are followed.
Say goodbye to your future tax tab
Even if Biden's tax plan doesn't go through, you still have a chance to win big with the Roth IRA.
By incorporating the Roth IRA into your investment strategy, you have a chance to sweeten the pot of rewards that you can access later, as long as you contribute the maximum now. That's because you'll have the power of compound interest working for you. Your money will keep earning more tax-free money for you to enjoy, no matter how much you earn during your golden years.
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