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How to Turn Taxable Income Into Tax-Free Income

How to Turn Taxable Income Into Tax-Free Income .

By Wayne Davies

Believe it or not, there are ways to convert taxable income into non-taxable income, without any fear of an IRS audit. Here's one of my favorites. It's been part of our tax code for over 30 years, yet many still don't take advantage of it.

What am I talking about? The IRA -- Individual Retirement Account.

Now, before you say, "Oh, I know all about that one; what's so great about an IRA?", give me 10 minutes to explain 3 new benefits to the IRA rules that you may not realize.

BENEFIT #1: How To Avoid Tax Rather Than Postpone Tax

First, did you know that there are now 2 kinds of IRA's available? The so-called Traditional IRA is the one that first came out way back in the 1970's. But there's a newer version of the IRA -- it's called the Roth IRA. And the difference between these 2 IRA's is huge.

Traditional IRA contributions are tax-deductible, resulting in immediate tax savings. The growth of those contributions is also tax-sheltered while the funds remain in the account.

But eventually all tax-deductible Traditional IRA contributions, as well as the growth of those contributions, will be subject to income tax when the money is withdrawn from the account. In other words, Traditional IRA's offer the opportunity to temporarily postpone taxes.

In contrast, the Roth IRA offers the opportunity to permanently avoid taxes. With a Roth IRA, you don't take a deduction for your contributions; instead, you make a contribution with "after-tax" dollars. Whatever you put in not only grows tax-free, but can also be withdrawn tax-free.

Here's an example to illustrate: If you invest $2,000 per year for 20 years into a Roth IRA, you will have invested a total of $40,000. Now if that Roth IRA earns an average of 5% per year (compounded monthly), that $40,000 will grow to about $68,000.

Now comes the fun part: Assuming the IRA has existed for at least 5 years and you are at least 59 1/2 years old, you can withdraw the entire $68,000 tax free. In contrast, if this money had been invested in a Traditional IRA, the entire $68,000 would be subject to income tax as it is withdrawn.

In the Roth IRA, the $28,000 of growth is magically converted from taxable income to non-taxable income. Assuming you are in the 15% federal tax bracket, that's a savings of $4,200.

BENEFIT #2: Take An Extra 3 1/2 Months To Fund Your IRA

The deadline for contributing to your IRA is April 15 of the year AFTER the year for which the contribution made. So for Year 2008, you have until April 15, 2009 to put money into your IRA.

If you've already invested the maximum (more about that in a moment) by December 31, 2008, then you're done. No more money can go into the IRA for 2008. But if you haven't maxed out your IRA, you have until April 15 to do so.

Which brings me to...

BENEFIT #3: The Maximum Contribution Amounts Have Increased

For many years, the most you could put into an IRA was $2,000. Now, the maximum is $5,000 (assuming you have at least that much earned income from wages, salary or self-employment income). And if you are over 49, you can put in another $1,000, bringing the total maximum to $6,000.

A married couple, both age 50 or older, can put a whopping $12,000 per year into a IRA. Not too shabby, eh?

One final note about these Roth IRA rules: For married people, you can only contribute the maximum of $5,000 or $6,000 if your 2008 combined income is less than $159,000. If you are single or head of household, you can contribute the maximum if your 2008 income is less than $101,000.

For most middle-class folks looking for a perfectly legal way to permanently avoid tax (rather then merely temporarily postpone tax), the Roth IRA fits the bill.

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