The Impact of the Capital Gains Tax on Your Retirement

You have to plan for tax on your retirement savings in order to assure you are saving enough. This becomes particularly complicated when a number of your retirement accounts are designed for appreciation and not just income. Capital appreciation is a popular model for retirement accounts because it works well for this purpose; however, capital gains tax can eat away at savings if you are not careful.

Challenge of Capital Gains Tax

The main challenge of capital gains tax is there is no good way to legally avoid paying it. With a number of estate taxes, you can structure gifts, trusts and estates to reduce the burden you will have to take on through taxes. Unfortunately, capital gains tax is very solidly in place. This is to prevent high-income earners from growing their income with profitable investments and then not paying tax on this additional income. However, the tax applies to all taxpayers, even those with low income, albeit at a lower rate. Regardless of your income, if you earn money from a sale of an asset that has appreciated in its value, you will owe capital gains tax.

Planning for Capital Gains

There are a number of ways to plan for a capital gains tax that can help you pay the IRS on schedule. One option is to aim to balance capital gains with capital losses. Capital losses can be deducted from your capital gains tax each year. For example, if you know you have a very high tax liability on a specific sale, you can sell an asset at a loss in order to reduce the tax. This works only with specific types of assets. Another model is to reinvest the capital you earned from one sale into another capital investment. You can then defer the capital gains tax until some point in the future.

Tax-Deferred Accounts

Some accounts provide for tax deferment on all capital gains. These accounts include qualified plans and independent retirement accounts (IRAs). Qualified plan is a term that generally describes one of the many options for employer-provided retirement accounts, such as 401k or 403b accounts. Both traditional IRA accounts are also tax-deferred options. You do not have to pay any capital gains tax on appreciation within the account until you make a withdrawal of these funds in the future. Waiting until you fit into a low tax bracket in retirement will greatly reduce the effect of capital gains tax on your account.

Tax-Free Accounts

There is one type of account that grows entirely tax free: a Roth IRA account. Roth IRAs use after-tax dollars on the front end. Once you make a contribution, though, you are not taxed on earnings while the account is active or after you have reached a qualifying event to begin withdrawing funds. This can be the most favorable way to eliminate capital gains tax on an investment. However, there is a limit to the total funds you can contribute to this account each year. As a result, only a small amount of your investments can receive this preferential status.

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