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Income tax, and taxation in general, has been the highest expense for the middle class over the last century. If you evade and cheat on your taxes all together, you could wind up with a special seat reserved for you in federal prison. However, there are completely legal ways to both reduce your tax burden and invest your money.

The tax-deferred vehicle we are talking about today is the Individual Retirement Account, or IRA.

IRA’s were started back in 1975 as a supplement for individuals to save for retirement as pension funds began to phase out. Workers were never meant to store all of their retirement savings into just individual accounts, but nowadays it is very rare that you find an employer that actually pays a pension.

What can I invest in with an IRA?

IRA’s are tax deferred investment accounts that enable the individual to store pre-taxed money within this account, and invest that money in a multitude of financial assets. These assets can be financial assets such as cash, bonds (debt instruments), mutual funds, annuities, commodity contracts, and even physical property like real estate and precious metals.

Normally, when you invest in something and it is paying you a dividend, you must pay income tax. Alternatively, if you sell the asset with a long-term gain, you pay your appropriate capital gains tax.

Requirements

In these IRA’s your investments grow tax free, highly increasing your potential long term growth. However, with IRA’s there are a few catches.

Contribution limits

IRA’s can be used by anyone within any tax bracket besides those over age 70 and a half. While eligible for contribution you can only contribute a total of $5,500 per year, or $6,500 if you’re over the age of 50. This money goes into your account before it is taxed by the IRS and this way is able to grow tax free.

RMD’s

Another rule with an IRA is that once you turn 70 and a half, you must start taking required minimum distributions (RMD’s) or suffer a 50% penalty charge by law. These distributions are then taxed at your current income tax bracket for that year.

There is a lot of flexibility to the IRA, but it is by no means a one size fits all solution. The downside to the IRA is that you must pay taxes on the back end when you withdraw. We have no idea how high taxes could be when that time comes.

There are many rules and regulations that go into IRA’s so it is important to consider consulting with a tax professional and/or a financial advisor before planning to use one.

Conclusion

Traditional IRA’s tend to be the go-to option for individuals who have a high level of income and need some sort of tax relief in the current year. If you have the option, consider looking into other tax deferred vehicles like the Roth IRA or Real Estate.

 

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