Tax brackets for 2020 make many subtle changes to the previous year, CNBC reported. Standard deductions, employee contributions to 401(k) plans, and more have all been boosted. Tax shelters can also be a boon for your savings.
According to the CNBC article, a number of notable changes to various life-planning accounts have been placed in effect this year compared to 2019. Traditional and Roth IRAs as well as health savings accounts have gone up, and that’s not all. “Good news for people sitting on millions: The Tax Cuts and Jobs Act nearly doubled the amount that decedents can bequeath in death—or gift over their lifetime—and shield it from federal estate and gift taxes, which are 40 percent,” the article said.
Of course, all of this sounds alien to taxpayers unfamiliar with the ins and outs of the Internal Revenue Service. Fortunately, getting to know some common tax shelters isn’t as daunting as it sounds.
Definition of an IRA
When planning ahead for your financial future, one of the most popular savings accounts is an Individual Retirement Account (IRA). But what exactly is an IRA?
“According to the Investment Company Institute, an IRA is a trust or custodial account set up in the United States for the exclusive benefit of an individual or an individual’s beneficiaries,” said Dr. Ramon P. DeGennaro, CBA Professor in Banking and Finance at the University of Tennessee, Knoxville. “That definition is fine for technically minded folks, but I like to think of an IRA as just a special label that we stick on investments.”
Where this matters for most taxpayers is in its benefits. “What’s special is that investments with this label, including stocks, get a tax break,” Dr. DeGennaro said. “The same goes for a specific type of an IRA—a Roth IRA—or a 401(k) account, for that matter. You can put your IRA label on most of the stuff you’d typically hold, including stocks, bonds, mutual funds, and exchange-traded funds.”
There are also two types of IRAs—traditional and Roth. According to Dr. DeGennaro, the biggest difference between them is “when you get your tax break.” Traditional IRAs give their tax breaks right off your taxable income. On the other hand, investments in a Roth IRA don’t return as tax deductions at the end of the year, but any earnings on the Roth investment are essentially tax-free. IRAs are complex and nuanced, so it’s best to know the biggest differences between them before consulting a professional.
Bare Bones of the 401(k)
Many companies with full-time employees offer benefits that include a 401(k) retirement plan, which, Dr. DeGennaro said, functions similarly to a traditional IRA since the contributions made by participants don’t count as taxable income when they’re made, and only taxable when money is withdrawn.
“Just like in an IRA, you build a much bigger nest egg than you would in a fully taxable account in almost all cases,” he said. “401(k) plans have been gradually replacing pensions as the primary source of retirement income in the United States for several years.”
Dr. DeGennaro also said it makes far more sense to place a heavily taxed investment such as high-dividend stocks into a tax shelter like an IRA or 401(k). “Some people think that because your IRA or 401(k) investments are long-term, you can afford to put risky stocks—which tend to be low-dividend stocks—in them because the variation in your return evens out over time,” he said. “But […] this argument is simply wrong! The longer you stay in the market, the more risk you bear, not less.”
Regardless of your personal philosophy for financial planning, it may require some adjusting due to the new tax brackets for 2020. Consult a professional financial planner with any questions you may have and your nest egg could end up working for you in ways you’d never imagine.
Dr. Ramon P. DeGennaro contributed to this article. Dr. DeGennaro is the CBA Professor in Banking and Finance at the University of Tennessee, Knoxville. He also served as a Visiting Scholar at the Federal Reserve Banks of Cleveland and Atlanta and for the American Institute for Economic Research. Dr. DeGennaro holds a Ph.D. in Finance from The Ohio State University.