The old saying that nothing is inevitable except death and taxes is true. Congress does provide a tax incentive to encourage people to save money for certain things, such as retirement, medical expenses and college costs, but at some point, you're going to have to pay at least some tax on that revenue. The exact procedures depend on whether your money is currently in a tax-deferred savings vehicle, such as a traditional IRA or 401(k), where you don't pay taxes during the growth phase but you do pay taxes on money as it's withdrawn, or if it's in a regular account in a mutual fund company, brokerage or bank.
1. Check your eligibility to contribute to a Roth IRA. Roth IRAs don't offer a current tax deduction on contributions, but once the money is in the Roth IRA account, and stays in that Roth for at least five years, you are never taxed again, either on capital gains or income when you take the money out. You can find the Roth IRA eligibility criteria in IRS Publication 590, "Individual Retirement Accounts." The maximum contribution is $5,000 per year, as of 2011, for most taxpayers. Those over age 50 can contribute $6,000, provided they meet the income limits. If you are married, you can open another Roth IRA on behalf of your spouse. However, you can roll money from a traditional IRA into a Roth IRA even if you don't meet the income limits.
2. Establish a Roth IRA account. You can do this by contacting the brokerage company, mutual fund company or insurance company of your choice. If you are eligible to contribute to a Roth IRA, move your money that is in taxable accounts to your checking account, then send a check to the investment company with instructions to credit your contribution to your Roth IRA. Understand that if you sell anything at a profit, you may have to pay capital gains taxes on money you are pulling out of taxable accounts to contribute to the Roth.
3. Execute a rollover from retirement accounts into a Roth. Tell the investment or insurance company to do a trustee-to-trustee transfer from a traditional IRA, 401(k), Keogh or other plan as appropriate. You will need to pay income taxes on any amount you roll over from these accounts to a Roth. However, you would need to pay income taxes on income you take from these accounts anyway.
4. Get a medical exam. If you are in good health, you can purchase a permanent life insurance policy. Cash value in a permanent life insurance policy grows tax free and can provide tax-free income, provided the policy is structured not to become a modified endowment contract (MEC), which can happen if premiums are too high relative to the policy's death benefit. The tax treatment is similar to that of a Roth IRA, but there are no age restrictions on accessing your money. To maximize the growth of the cash value, opt for a low permanent death benefit and pay as much premium into the policy as you can without turning it into a MEC. This strategy works well for those who earn too much for the Roth or want to shelter more money from future taxation than a Roth will allow and, of course, who need or want a permanent death benefit. Mutual life insurance companies tend to accumulate cash value faster than non-mutuals, because dividends get credited to the policy cash value, tax-free.
5. Check with your employer about designated Roth accounts in 401(k)s. Some companies allow employees to contribute to 401(k) accounts with similar tax characteristics to a Roth IRA. If your employer is among them, this may help you move more money into tax-free accounts than you could using a Roth IRA alone.
- Investment companies tend to sell more aggressive products with higher expected returns, but with a relatively high degree of uncertainty and the significant risk of loss as well. Insurance companies tend to focus on insured products, such as annuities, which offer more modest expected rates of return, but also provide more guarantees on your savings plan.
- If your family relies on your current income, be aware that term insurance coverage for younger workers is much less expensive per dollar of death benefit than permanent coverage. Consider your family's total death benefit need when developing your life insurance strategy, and don't focus exclusively on cash value growth.