The following is
my answer to a Quora question: “I am an independent
contractor. and make decent money. I
invest most of my savings in low-cost index funds, and stocks. Should I also set up an IRA? What advantages would it have over just
adding to my current accounts?”
Since you use the term “IRA”, I am
assuming that you are based in the US, and this answer is according to
prevailing tax law there. The US has a
capital gains tax. This means whatever
you earn in your funds and equity holdings is subject to tax. You may mitigate this by investing through
some sort of vehicle, allowing you to expense out some expenditure to mitigate
your tax liability.
However, the IRA allows you to defer your
tax to when you take out from the fund, or when it reaches maturity. Theoretically, this means one large lump sum
tax bill, instead of a bill every financial year. If you have a competent financial advisor, or
you are confident that you are able to bring in a return that exceeds what you
would nominally pay for that tax, and the prevailing rate of inflation, you
could conceivably pay less tax than if you had paid that tax annually by not
having your funds in an IRA. The
assumption here is that instead of paying your tax in the interim, you use that
difference to invest further to increase your earnings, and allow it to
compound for greater potential gain. That
is an “if”.
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