A less taxing situation

This being March, if you are eligible and have not done so already, it’s not too late to think about reducing your 2012 taxes by investing in an IRA.

Most people would look only at cash as a source of funds, but sometimes it makes sense to liquidate taxable investments to invest in retirement accounts if excess cash is unavailable. (Care has to be taken about triggering capital gains and keeping the overall portfolio balanced properly.)

This can produce significant benefits. Those eligible to invest in a traditional, deductible IRA receive an immediate tax deduction that generates a first-year return equal to their marginal rate of taxation. (See IRS Form 590 for eligibility rules and contribution limits. Consult with a financial advisor and your accountant.)

As an illustration, suppose a 50-year-old single person has a taxable income of $50,000 and a combined state and federal marginal tax rate of 32 percent. If she invests $5,000 in an IRA, her 2012 tax bill declines by $1,600.

After 20 years, the IRA, under certain assumptions, could be worth about $19,000 vs. about $15,000 for the non-qualified “retail” account.*

The money would be locked away and, with some exceptions, could not be withdrawn without penalty before age 59.5. The investor would need to be sure not to require the money before that age, and ideally would have enough cash on hand to meet emergencies (typically three to six months of basic living expenses) and to pay for large one-time costs coming up in the next two years (a vacation or new boiler, for example).

The woman in our illustration would be required to start taking (taxable) withdrawals from the IRA at age 70.5. By this point, she may well be retired and be taxed at a lower marginal rate. Meanwhile, the money still in the IRA would continue to grow on a tax-deferred basis.

(IRAs are among the trickiest areas of investing. Among the things to consider are the advantages of a Roth vs. a traditional IRA. Some people would be better off contributing to a Roth, which does not offer a deduction on contributions but provides tax-free withdrawals.)

Workplace retirement plans such as 401(k) or 403(b) plans offer even greater potential to reduce taxes because they have higher contribution limits. Unfortunately, it’s too late to reduce your taxes for 2012 by making contributions this year to a 401(k) or similar plan.

Just as people think they need spare cash to invest in an IRA, a lot of folks believe they need excess cash flow from their salaries to be able to increase 401(k) plan contributions. A lucky few, however, have taxable accounts in the high five or six figures from an inheritance, insurance settlement or home sale; they may be able to contribute more to their 401(k)’s while drawing down their taxable accounts to subsidize their living expenses. They are not spending the money; they are moving it from a taxable pot to a tax-favored pot. It’s not a pot of honey, but it can mean a lot of money.

*Assumes investment return of 7 percent in IRA and post-tax return of 5.75 percent in taxable accounts. The IRA value would be yet higher if the tax savings on the deduction were also invested in the IRA in the subsequent year.

Consult your financial advisor and accountant. These are general comments that may not apply to your specific situation.

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Update on smart phone budget app

I have been using the iPhone HomeBudget app for two months and I am very impressed.

During the first month, I tracked my expenses on my phone and added the spending my wife tracked on her own that she told me about later. Bought groceries – entered it on the phone, purchased Brooklyn Nets tickets, grabbed the device (OK, sometimes there was a lag …).  I got a clear, easy picture of how much I was spending and where it was going, complete with pie charts and trend lines. This month, we synced our iPhones and now the expenses my wife adds on her phone, I can see on mine and vice versa.

The application allows me to create whatever spending categories or subcategories I want beyond the basic categories. I can add one-time or recurring expenses and compare our earnings with our spending. The product does not rely on sometimes balky downloads from financial accounts, which in my experience bedevil Mint.com. Best of all, the app is not overloaded with features – it has just what I need for budgeting.

My wife, Lynne, said she finds the app “kind of fun” and “very easy to use.” For Lynne to be upbeat about anything involving finance speaks volumes.

This article is for informational purposes only, and Garrett Investment Advisors, LLC, does not endorse any products or services that may be mentioned.