- April 19, 2024
- Posted by: legaleseblogger
- Category: Related News
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Last year, the individual moved their savings to a Money Market high yield savings account and accrued enough interest to receive a 1099 form. However, when they entered the interest on their tax return, their tax payment increased by about $100. Anticipating more interest income this year, they are seeking ways to minimize their tax liability and maximize their savings.
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The individual is hesitant to replace their High Yield Savings account, which serves as their home down payment fund. They also have a 401K and are exploring options to minimize taxes while maintaining access to their savings. With a salary of $80,000 per year, no debt, and a low-cost lifestyle, they are planning for a potential car purchase in the near future.
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>I have a vague understanding that a Roth IRA will shield part of my income from tax.
A Roth IRA won’t, but a Traditional IRA will.
>I’d really just like to figure out the least amount of money I need to put in an IRA to counter act 2-3K of anticipated interest income this year.
You can deduct whatever amount you contribute from your taxable income. So if you want to offset 2-3k of taxable interest income, you need to contribute 2-3k to the traditional IRA.
>I make 80K/year
There are income limits for taking IRA tax deductions, which you are getting close to. If your 401k is decent, you may elect to increase those contributions instead. It’ll have the same effect.
A Roth won’t shield your income from taxes. A Roth gives you tax free growth, meaning you won’t owe tax when you take it out in retirement. In exchange for this benefit, you make the contributions today post-tax, and you don’t get a tax deduction for it.
In order to offset income, you want to contribute to a pre-tax, traditional IRA, or 401k. I will reiterate what another poster said – If you want to offset $2k in extra high-yield savings income, you would want to contribute $2k into an IRA or 401k (NOT a Roth).
But keep in mind, you will be taxed on that IRA/401k income at retirement (unless it’s a Roth). So you’re gonna owe taxes either way, just depends on when you wanna pay them. Uncle Sam wants his. There’s no magic trick to avoid tax, it just depends on when you want to pay it. Paying income tax is a fact of life – it simply means you made money.
By contributing to an IRA now to negate income from a high yield savings, you’re basically saying, “I don’t need this extra income now, I’ll take it at retirement instead and pay the income tax then.” That might not align with your current goals, considering you’re saving for a house/car.
If you’re *already* contributing to a retirement account, I really don’t see the benefit to you in contributing extra *simply* to offset your HYS income at this time. Of course if you haven’t been contributing anything at all to a retirement account, yesterday would be a great time to start.
If your goal is to simply avoid an extra bill at the end of the year (and not to avoid paying your annual income taxes) – adjust your withholdings on your W4 at work. If you anticipate making an extra $2-3k in interest this year, adjust your withholdings to take an extra $10-20 out of every check so the IRS gets what they are owed throughout the year and you aren’t paying it at the end.
You can (maybe) shelter money from taxes, but you will have to lock more money into retirement accounts than you save. It’s a good deal in the very long term, but it won’t help you buy a house.
Making more money in interest is good, consequently you will have to pay more in taxes. Don’t jump through too many hoops to avoid these taxes unless it’s part of your larger personal finance plan. If you want to contribute to an HSA or a traditional IRA or shift your 401k contributions from Roth to Traditional as part of your larger plan, great. If you’re doing it solely to change this year’s tax refund, your plan is being dictated by your tax situation rather than your long term needs.
You can reduce your tax burden by reducing your taxable income. One way to do it is by maxing out your 401k contributions ($23k per year for CY2024)
Try not to be penny wise and pound foolish.
Taxes should not be a primary focus of your investment strategy. Risk adjusted return should be your primary focus. After several investment choices are determined, then consider the tax implications of each.
The main difference in return between a Traditional IRA and Roth IRA is the tax bracket when the contribution is made v.s. the tax bracket when the money is distributed.
Assuming your age is below 59.5, early withdrawal penalties may be more than the income protected by putting the money in an IRA. Especially since this is your home down-payment money, which you’re likely to need within 5 years.
Generally, tax-free fixed income investments are priced to match the after-tax return of a similar taxable investment for someone in the highest or near highest tax bracket. If you’re not in a high bracket, the tax-free investment is likely to provide a lower return than a similar taxable investment.
Paying taxes is a sign of success. I’d rather pay $300 in taxes on $1500 income, than $0 taxes on $1000 income.
Lots of good answers already, but I’d like to add 2 things you may not have considered as far as taxes go.
1. Cash or stocks in Roth IRA are post-tax money, so they will not be taxed. This includes uninvested cash sitting in your cash core account. For Fidelity, this cash sits in SPAXX, which currently pays 4.95%.
2. If you’d like to earn a high amount of interest in the current environment risk-free without being taxed by state, you can buy treasuries on TreasuryDirect and you will only be taxed federal, not state. This is how you get the high interest rate, similar to what you’d get in SPAXX or a HYSA, but without the state tax (which is anywhere from 0-10% depending on state and income level)
You used “Roth IRA” and “IRA” interchangeably here, they are not the same.
Roth, whether 401k or IRA, you pay taxes now and then no taxes when withdrawing for retirement.
Non-Roth, no taxes now but taxes when you withdraw for retirement.
In either case you aren’t really escaping the taxes.
The $100 hit to your taxes may have just been that you were at a tipping point of the tax brackets.
EDIT: Restating $100 part since what I said was dumb (thanks other commenters). Even the lowest income tax bracket the $100 tax owed is accurate to $1000ish gain. Why it “seems” like a lot if probably just because you’ve done it at the end after all other deductions etc have been calculated
You may find these links helpful:
– [Retirement Accounts](/r/personalfinance/wiki/index#wiki_retirement)
– [“How to handle $”](/r/personalfinance/wiki/commontopics)
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Contributing to a Roth won’t lower your tax bill because it’s after tax money. To lower your tax bill you should contribute more to your traditional 401k, which is pre-tax. You’re in the 22% tax bracket, so contributing an additional $10,000 to your 401k would decrease your taxes by $2,200.
Roth IRA won’t change anything around a given year’s taxes. Money put into that type of account remains part of your taxable income.
Earned interest is taxed exactly like your job pay, there’s just no withholding done for it so no pre-payment. You could contribute more money into a pre-tax retirement account (work 401k, Traditional IRA unless you’re ineligible for deduction) equal to the amount of interest. That additional retirement savings would effectively cancel out the taxable income from your HYSA.
The real “fix” is to account for that interest income in your tax planning. $100 owed is not a big deal to just pay along with your filed return, as long as you expect it. And after this experience, you should now expect it for future years.
If you wanted to cover that owed tax over the course of the year instead of with your return, you could simply put a dollar amount on the “Additional Income” line of your job’s W-4 equal to your estimated interest earnings. Payroll will then add in that dollar amount when calculating your withholding, and you’d have about $4 per paycheck extra sent to the IRS above what just your pay would do.
Others have answered the IRA question, but just wanted to say that I was in a similar situation. It is income so it should be taxed. You can either adjust your W-4 to pull a couple extra dollars out towards taxes every paycheck (what I did), or sit on it and just be ready to owe that much in taxes at the end of the year
Best way to reduce tax liability is to reduce your MAGI. Ignoring the fact that what you pay at tax time does not reflect your total tax liability (you earned $1000 and didn’t pay taxes on it until tax time), if you want to reduce your MAGI without reducing your salary, increase contributions to your 401k.
If you want to reduce the taxes paid at tax time, and not contribute more to your 401k, you could look at government bonds and bills, some of which are not taxed by some jurisdictions.
Another option is an HSA/FSA for medical expenses or dependent care FSA if you have children in daycare.
If you have an HSA you can do the same thing except no income limits for deductions. Can just invest it the same way as a 401k and either use if needed or leave invested until you retire and just use for medical then.
I moved my extra money to a Municipal Fund (Fidelity) and all the interest is now tax free. Check out Fidelity’s FTEXX. I like that it’s accessible, not locked up in an IRA. But also no tax implications.
That interest is income and it’s going to get taxed eventually some how. There’s no way to just never pay any taxes on it. If you throw money in a 401k it just gets taxed later when you pull it out in retirement. If you need it to be liquid for a future car or house payment, then you have to pay taxes on it now, because it is income.
To counter act 2-3k of income, you’d need to put 2-3k into a tax exempt or tax deferred account.
You’d just contribute more to your traditional 401k to counteract any increase in income taxes from interest income. Roth would be a better avenue for saving for a home even if you pay more income tax near term
If you don’t have an IRA yet, Roth or not, it’s a good idea to look I to it. But it’s fundamentally a different tool compared to a HYSA!
For short-term savings you absolutely want a HYSA (or similar tool – treasury ETF, treasuries, CD …), and it’s a fact of life that interest an all of these is taxable as ordinary income in the US. You aren’t losing anything – you only paid $100 in taxes because you gained $1099 in interest income.
The easy way to deal with this is to have a savings account labeled “taxes”, and each time you earn interest, you stick a percentage of it (maybe 12-15% for you) right into the “taxes” account as if it had never been yours. Or so a tax sweep every quarter, as long as your interest and dividends don’t exceed a few 1000 dollars.