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Contribute to an IRA and Save on Taxes Now

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Many people invest in traditional individual retirement accounts (IRAs) because they’re told these accounts offer a good way to save for retirement. And it’s true!

One of the biggest reasons why? You get to invest money in an account that can grow tax deferred until retirement. In other words, you can save money now and take advantage of the fact that you won’t be on the hook to pay taxes on investment returns (interest, dividends and capital gains) until you take the money out later in life.

What is it about tax deferral that’s so great when it comes to saving for your financial future? Essentially, this is a legitimate, legal way to avoid paying taxes if you use your traditional IRA in the right way.

Here are the specific types of tax deferral you can take advantage of when you save for retirement in an IRA – along with why they make a powerful impact on your nest egg.

Should You Save for Retirement or Pay Down Your Mortgage?

Example 1: No Taxes on Investment Returns

As mentioned above, the money you invest in your IRA can grow and you don’t have to pay taxes on interest, dividends, and capital gains that you earn by investing in stocks, bonds, mutual funds and exchange-traded funds.

That means you can buy and sell investments and not worry about the tax consequences as long as you keep that money in the IRA account.

Not having to pay taxes right away benefits you because it may boost your ability to save. If you have to account for taxes on your investment returns, which may cut into the amount you can actually contribute to your account. But since taxes are deferred, you can take advantage and save more right now – and allow compound interest more time to go to work for you and your investments.

Example 2: No Taxes on Current Income

An even better benefit comes in the form of income tax deferral. In certain situations, you may be able to avoid paying taxes on a portion of the income you earn in any given year by contributing to an IRA.

Here’s an example: Let’s assume you’re eligible for tax deferral and you’re in the 25% marginal tax bracket. (Without getting into too much detail, this means you make between $37,450 and $90,750 if you’re single and between $74,900 and $151,200 if you’re married and choose to file taxes jointly with your spouse.)

If you contribute $5,500 into your IRA this year, you’ll receive a deduction on your tax return in the amount of $1,375. Put another way, it feels like you only invested $4,125, which your wallet will appreciate. This is because you don’t actually pay ANY income taxes on the $5,500 until later (typically in retirement).

Since you don’t pay taxes on that money, that means you get to invest the full $5,500 – rather than just $4,125. That’s the amount you would have had to invest in a normal brokerage account if you actually had to pay $1,375 in taxes to the IRS. Thanks to the deduction, you don’t have to.

Over time, this can add up to a significant amount of investment growth in your IRA making tax deferral a very powerful factor. Just think about the amount you can save in taxes over your working years if you continue to invest $5,500 into your IRA every year. (That’s the maximum amount you can contribute to an IRA in 2015 if you’re under 50. The amount rises to – $6,500 for anyone over age 50.).

Make Sure You Take Advantage of Tax Deferrals

So, how do you take advantage of tax deferral inside an IRA? Well, to receive the benefit of the example number one above, you simply have to earn an income. If you do, then you can open an IRA and begin investing up to $5,500 every year that you earn a wage.

Once you hit 50 years old, you can then contribute another $1,000 per year. (These limits will continue to increase with cost of living adjustments.)

Example number two is a little tougher to qualify for. In order to deduct the amount of money you contribute to your IRA, you must not have access to another retirement plan elsewhere, typically through work. If, for example, your company offers a 401(k), then you have access to another plan. And if you do have that access, you cannot deduct your IRA contributions (there is an exception noted below).

The key phrase here is “have access to” because it doesn’t matter if you actually contribute to the employer plan or not. You are still not eligible for a tax deduction on IRA contributions because you could have contributed to that 401(k). Before you get too bummed out, know that, you do get the same tax benefit explained in example two by contributing to your employer’s retirement plan so you’re still in good shape. Plus, you may even get a matching contribution from your employer, which is something you won’t get in an IRA.

There is one exception to this rule. If you make less than $61,000 in any one year, you can deduct your IRA contributions even if you have access to another retirement plan at work ($98,000 if married filing jointly and $10,000 if married filing separately). You may also be eligible for a partial deduction depending onyou modified adjusted gross income. Find the IRS chart here.

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One More Tax Advantage to Use in Your Favor

If you’re not excited about the opportunities to take advantage of saving on your taxes now while simultaneously saving for your financial future, here’s a bonus for you: if you haven’t contributed the maximum amount to an IRA for the 2015 tax year (or even opened up an IRA yet), you have until you file your taxes or the April 15 deadline to contribute for last year!

Why would you do this? Well, the more money you get into your IRA, the more money you have working for you for retirement on a tax-deferred basis. If you have the funds available, it’s a great opportunity to increase your retirement nest egg.

Plus, if you just realized that you owe taxes for 2015 and you are eligible to receive a tax deduction by contributing (see rules above), you can reduce a percentage of the taxes owed so you don’t have to pay as much.

It’s yet another win-win situation offered by contributing to your IRA!

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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Life Events, Mortgage

What is Mortgage Amortization?

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The difference between your home’s value and how much you owe on your mortgage is your home equity. With each mortgage payment you make, mortgage amortization — or paying down the loan in installments — is at play, and each monthly payment brings you closer to owning your home outright.

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What is mortgage amortization?

Mortgage amortization is the process of paying off your loan balance in equal installments of principal and interest for a set time period. The interest you pay is tied to the balance of your loan (your principal) and the mortgage rate. When you first start making payments, most of the payment is applied to the interest rather than the principal.

Your principal payments catch up with interest over time until your loan is paid off. Once it reaches a zero balance, it becomes a “fully amortized loan.”

How mortgage amortization works

The easiest way to understand mortgage amortization is to look at how monthly mortgage payments are applied to the principal and interest on an amortization table. There are two calculations that occur every month.

  1. The first calculation measures how much interest is paid based on the rate you agreed to. The interest charge is recalculated each month as you pay down the balance, and you pay less interest over time.
  2. The second calculation reflects how much of the principal you pay. As the loan balance shrinks, more of your monthly payment is applied to your principal.

If you’re a math whiz, here’s the formula:

A mortgage amortization calculator does the heavy lifting for you. You can see the effects of amortization on a 30-year fixed loan amount of $200,000 at a rate of 4.375% below.

In the first year, you pay more than twice as much toward interest as you do toward the principal. However, the balance slowly drops with each additional payment. By the 15th year, principal payments outpace interest and equity starts building at a much faster pace.

How mortgage amortization can help with financial planning

A mortgage amortization table helps you assess the short- and long-term benefits of adjusting your mortgage payments. Making extra payments over the life of the loan or refinancing to a lower interest rate or term could save you thousands in interest charges over the life loan. Even better: you’ll end up with a mortgage free home sooner.

Using a mortgage calculator to configure a few scenarios, here are some financial goals you might be able to accomplish using mortgage amortization.

Calculate how much money you can save by refinancing

If mortgage rates have dropped since you bought your home, consider refinancing. If you’re in your forever home and don’t plan to move for a while, a half-percentage point drop in rates could make room in your budget to boost retirement savings, your emergency fund or put money toward other long-term financial goals.

The example below shows the monthly payment and lifetime interest savings if you replaced a 30-year, fixed-rate loan for $200,000 at 4% with a new loan with a 3.5% interest rate with the same terms.

While saving $56.74 per month on payments doesn’t seem like much, it adds up to $20,426.83 in interest savings over the loan’s lifetime.

See the effect of making extra payments

The amount of interest you pay every month is directly connected to your loan balance. Even a small amount added to the principal each month reduces interest over time. The graphic below shows how much you’d save adding an extra $50 every month to your payment on a $200,000, 30-year fixed loan with an interest rate of 4.375%.

Figure out when you can get rid of PMI

Borrowers who don’t make a 20% down payment on a conventional mortgage typically pay for private mortgage insurance (PMI). The coverage protects a lender against financial losses if you don’t repay the loan.

Once your loan-to-value ratio, or the loan balance in relation to the home’s value, reaches 78%, PMI automatically drops off. Multiply the price you paid for your home by 0.78 to determine where your loan balance would need to be for PMI to be canceled. Locate that balance on your loan payment schedule for a rough idea of the month and year PMI will end.

Decide if it’s time to refinance an adjustable-rate mortgage

Adjustable-rate mortgages (ARMs) are a helpful tool to save money on monthly mortgage payments. However, ARMs make more sense if you plan to refinance the loan or sell your home before the initial fixed-rate period ends and the loan resets to a variable interest rate.

An adjustable-rate mortgage amortization schedule helps you pinpoint when the loan will reset and gives you an idea of the worst-case scenario on payments. If the adjustments are outside of your comfort zone, consider refinancing your ARM into a fixed-rate mortgage.

The difference between a 15-year fixed and 30-year fixed payment schedule

Refinancing to a shorter term, such as a 15-year fixed mortgage, may save you hundreds of thousands of dollars over the life of a loan — but the trade-off is a higher monthly payment.

The graphs below show the difference between a 30-year amortization schedule for a $200,000, fixed-rate loan at 4.375% and a 15-year amortization schedule for the same loan amount at 3.875%.

The lifetime interest savings for a shorter loan payment schedule is $95,447.16. As long as the $468.31 increase in your mortgage payment doesn’t prevent you from meeting other savings or investment goals, the long-term savings are worth it.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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Life Events

When Do You Need to Start Taking Required Minimum Distributions (RMDs)?

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When you reach age 72, the government requires you to begin withdrawing money from your retirement savings accounts each year. This sum, known as a required minimum distribution (RMD), allows the IRS to begin collecting income tax on the dollars you’ve stashed away in tax-deferred accounts such as a 401(k) or traditional individual retirement account (IRA).

What is a required minimum distribution (RMD)?

Regulations governing most retirement accounts state that you cannot leave funds in the account indefinitely. Even if you don’t need the money, the government requires you to begin reducing the overall balance in most accounts by a set sum each year — the required minimum distribution — once you’ve turned 72.

The precise amount of each person’s required minimum distribution is determined by the IRS based on life expectancy and total savings. The RMD rule only applies to tax-deferred accounts or accounts that allow people to reduce their taxable gross income each year by the amount they set aside in the plan.

Because tax-deferred accounts provide upfront tax savings, the IRS waits to collect taxes on contributions to the accounts and any subsequent investment gains until the money is withdrawn. Here’s a full list of retirement accounts subject to the RMD rule:

  • 403(b)
  • 457(b)
  • Profit-sharing plans
  • Other defined contribution plans

RMDs are not required for Roth IRAs or Roth 401(k)s, since contributions to Roth accounts are made using money on which you’ve already paid income tax. Note, however, that beneficiaries who inherit Roth IRAs must take RMDs.

When do I have to start taking RMDs?

You need to start taking required minimum distributions by April 1 of the year after you turn 72. In subsequent years, you need to take RMDs by December 31st.

If you are still working at age 72 and have a traditional 401(k) or 403(b) account with your current employer, you may not have to take an RMD from that account unless you own 5% or more of the company. Review your plan’s exact terms to see if it allows you to wait until you actually retire to begin taking RMDs or if it follows the same 72 rule regardless of retirement status.

Employment, however, won’t help you delay taking RMDs from any individual retirement accounts outside of your employer retirement account, such as a traditional IRA.

You do not have to take your RMD as one lump-sum payment. The IRS allows you to take out the funds in chunks throughout the year too. As long as the total meets the RMD for the year, you’re in the clear.

You’re also not limited to taking only the RMD amount from your account each year — you can withdraw more than that threshold, if you want.

How do I calculate my required minimum distribution?

Just like filing your taxes, it falls on your shoulders to remember to take the RMD once you reach 72. You can do the math yourself (we’ll explain below) to figure out what your required minimum distribution will be, or you can ask for help from a tax professional or financial adviser.

To calculate your RMD, you need to know exactly how much you have saved in your retirement account as of Dec. 31 of the previous year. Next, use the table below (the IRS’s Uniform Lifetime Table) to find your “distribution period” score, which is based on your life expectancy.

To calculate the RMD, divide your retirement account balance by the distribution period that corresponds with your age. Repeat this step for each of your accounts to come up with the total amount you must withdrawal for the year. Remember, your account balances change over time and the IRS can update its distribution period figures, so redoing this math each year is crucial to ensure you take out the correct sum.

Let’s say you turned 72 in December 2020 and had a balance of $1 million in your retirement account as of Dec. 31. You would then find the distribution period that corresponds to your age in the Uniform Lifetime Table.

According to the table, your distribution period number is 27.4. When you divide $1 million by 27.4, you get an RMD of $36,496.35. That is the minimum withdrawal you must make from that account by April 1, 2021.

However, if you’re married and your spouse is 10 years or more younger than you and is the sole beneficiary of the retirement account, you will need to find your “distribution period” score on this alternate table by locating the spot where your age and your spouse’s age intersects.

For instance, if you turned 72 in 2020 and had that same $1 million balance in your retirement account on Dec. 31, but were married to a spouse who’d just celebrated their 59 birthday, your distribution period number wouldn’t be 27.4, but rather 28.1 to accommodate the longer expected lifeline of your spouse.

And this would mean you’d need to take an RMD of $35,587.19 from your account in 2021, or about $909.16 less than you would if you were single or married to a spouse closer to your own age.

What is the required minimum distribution penalty?

If you don’t take your first RMD by April 1 of the year after you turn 72 or your subsequent annual RMDs by Dec. 31 each year, you’ll be slapped with a 50% excise tax on the amount that was not distributed when you file taxes.

That’s a steep fine when you consider that the top tax rate is 37%, which is why it is so important to accurately calculate your RMDs each year, as the tax applies whether you fail to take any money from the account or simply don’t take enough.

For example, if your RMD was $10,000, but you only took out $5,000, you will be assessed that 50% tax on the $5,000 that you did not withdraw.

Remember, if you delay taking your first RMD until April of the year following your 72nd birthday, you’ll be required to take two withdrawals in the same year, one for your 71st year and one for your 72nd year, which could raise your gross income and move you into a higher tax bracket. To avoid this, you can opt to make your first withdrawal by Dec. 31 of the year you turn 71, instead of waiting till the following April.

Alternatively, you could reduce your taxable income by making a qualified charitable distribution paid directly from the IRA to a qualified public charity, not a private foundation or donor-advised fund. The charitable distribution can satisfy all or part of the amount you are required to take from you IRA and won’t count as part of your income.

If you withdrawal the RMD first, then donate it, this trick won’t work as the money will count toward your gross income.

What if I have multiple retirement accounts?

If you have more than one retirement account, things can get a little more complicated. You still need to take an RMD, but you don’t have to take one out of each IRA account. Instead, you can total the RMD amounts for all your IRAs and withdraw the whole amount from a single IRA or a portion from two or more.

However, you can’t do the same with most defined contribution plans, like 401(k)s. With these accounts, you must take an RMD from each plan separately. One exception to this rule, though, is 403(b) tax-sheltered annuity accounts. If you have multiple of these accounts, you can total the RMDs and withdrawal from a single account.

If you own several different kinds of retirement accounts with RMDs, it’s probably a good idea to seek advice from a tax or financial adviser professional who can help you make the wisest decision for your finances.

I inherited a traditional IRA — what should I do?

While it’s great to be left the generous gift of a retirement account by a loved one, inheriting an IRA comes with its own set of tricky RMD rules that can vary greatly depending on your relationship with the original owner and how you chose to use the account.

I inherited a traditional IRA from my spouse

If you’re a spouse and sole beneficiary, you have the most flexibility in how to handle your new IRA. You can choose to treat the IRA as your own by designating yourself the account owner and making contributions or by rolling it over into an existing IRA account that you own. If you choose this option, you can follow the standard RMD rules — meaning you can wait until you turn 70½ to begin taking money from the account.

Alternatively, you can roll the assets into what’s known as an inherited IRA. With this kind of account you can start taking distributions immediately and not face the typical 10% early-withdrawal penalty the IRS applies if you’re under age 59½.

To calculate the RMD you’ll need to take with this kind of IRA, use the IRS’s Single Life Expectancy Table, which has different distribution period figures than the standard table you would use if you were the original account owner. You can opt to use your own age for these calculations or your partner’s age as of their birthday in the year they died, reducing life expectancy by 1 each subsequent year.

But you may not need to take RMDs right away depending on how old your spouse was when they died. If they were older than 70½ then you’ll need to start withdrawing funds by Dec. 31 of the year following their death. But if they were younger, the IRS lets you leave the money in the account until your spouse would have reached 70½.

I inherited a traditional IRA — but I’m not a spouse

Beneficiaries who are not a spouse are required to move the assets into an inherited IRA and begin taking RMDs regardless of the original owner’s age. If the person passed before age 70½ you can opt to withdraw the full balance within the five years following the year of their death. Or you can prolong the payouts by taking RMDs annually based on your age, reducing beginning life expectancy by 1 for each subsequent year, using the Single Life Expectancy Table.

If the original owner was 70½ or older, how you calculate your RMDs depends on whether you or the deceased was younger. The lowest age is what you’ll base your life expectancy figure found in the Single Life Expectancy Table on, though you will need to reduce beginning life expectancy by 1 every subsequent year.

I inherited a Roth IRA — what should I do?

The original owner of a Roth IRA never has to take RMDs but that can change when the account passes to a beneficiary. A surviving spouse who inherits a Roth IRA can opt to treat the account as their own, meaning they won’t ever need to take an RMD, if they contribute to the account or roll into an existing Roth IRA.

Non-spouse beneficiaries, however, do have to take RMDs from an inherited Roth IRA, following the same rules as those who inherit traditional IRAs where the owner passed before reaching age 70½.

That means these beneficiaries can either withdraw the entire balance from the Roth IRA within the five years following the year of the original owner’s death or begin taking RMDs based on your life expectancy, as outlined in the Single Life Expectancy Table, by the end of the year following the owner’s death.

The final word on required minimum distributions

Whether the retirement account was yours to begin with or you’ve inherited it, calculating the correct RMD amount to withdraw from it every year can be tricky, but spending the extra time to make sure you understand the rules and check your math can pay off big time when you’re not losing 50% of your savings to Uncle Sam in the form of a tax penalty.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.