You hold two containers full of money: The amount that has been taxed already, let's name the taxed cash as "ordinary cash," and the non-taxed cash, i.e. IRA, 401k, 403b, as "retirement cash." It will cost you $1 at the time you expend $1 from the ordinary cash. But, when you spend the retirement cash, the real cost of $1 is effectively $1.51, due to the fact that you must pay the federal IRA tax ( and possibly state tax) on withdrawals. Therefore, if you want to reduce your IRA tax and your overall income tax bill, consider taking ONLY the required minimum IRA distribution from your retirement money.
Some people consider not spending their principal and are hesitant to do so. This can however be an error if you are interested in reducing the IRA tax. To benefit from the tax-deferral that comes with IRAs and retirement plans, spending of your ordinary cash first, even the principal, is more effective. While you spend the ordinary cash including the principal, remember that the retirement cash continues to grow, tax deferred. You make the IRS wait. Spending your funds in this order (non-IRA funds first) delays tax reporting on your income tax returns and reduces your IRA tax and your lifetime tax bill.
Consider the following hypothetical example that assumes you have a taxable regular money account and a tax-deferred retirement account with a $100,000 balance each (the table below illustrates). Say, the amount in the account gets a return of 6% per annum. Let's further assume that annual distributions of $6,000 per year are being taken for a 20-year period.
Under one scenario, the $6,000 will be taken first from the taxable money and the other scenario considers what would happen if the money was taken first from the qualified or IRA money. Considering this illustration, you should be able to have 140,000 dollars extra by the 20th year if you expend your ordinary funds at first. As IRA taxes are lower over one's lifetime (because the withdrawals are held to zero in our hypothetical illustration) the opportunity to accumulate more wealth is a big plus. Would an extra $140,000 help your retirement plan?
Surely, the disadvantage is that your benefactors will ultimately have to pay IRA tax on the IRA balance they inherit after your death. Since the data provided by this illustration is theoretical, real results will differ according to the performance of your funds.
Spend Regular Money First
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postage rates 2011 says
You may be able to deduct some or all of your contributions to your IRA.