IRA Tax Savings for Those Planning a Career Break
This article presents the use of a Traditional IRA savings account to reduce your net taxes and save you hundreds or thousands of dollars in taxes if you are planning on quitting your job or taking a leave of absence to travel long term or live abroad for a time. While this article is mainly aimed at people going abroad, this tax savings strategy is effective for anyone who is planning on experiencing a sharp decrease in income.
The basic idea behind this savings strategy is that before leaving home to travel you likely have a much higher income than you will have once you are abroad. The Traditional IRA allows you to average your income over two or more years, thus reducing your tax rate and the total amount of taxes you pay. Essentially, in the year or two prior to leaving your job or taking a leave of absence, you set aside money and use it to fund a Traditional IRA account. The money added to your IRA is subtracted from your Adjusted Gross Income (AGI) the year you contribute it, so you pay no taxes on the money that year. Then, in the year(s) you are abroad, you may draw out money from the IRA to pay your travel expenses. When you do this, you must then pay the taxes on this money, plus a 10% penalty. But since you are traveling abroad, your income is low or zero, so your effective tax rate becomes just the penalty, or 10%. And even the 10% early withdrawal penalty can be avoided if you plan carefully and meet certain requirements. Depending on what your tax rate was when you were adding money to the AGI, this strategy can represent a tremendous tax savings. The greater your change in income, and the more money you contribute to the IRA, the greater your savings.
For example: say your AGI is $40,000 and you file as single. Your maximum tax bracket (2011 tax rates) would be 25%. Contributing $5,000 to a traditional IRA would reduce your tax for that year by $1,250 ($5,000 x 25%). If you then redeem this $5,000 later when your AGI is zero, you would pay no taxes on this amount, only the 10% penalty of $500. That’s an overall tax savings of $750. If you can meet the requirements to avoid the 10% penalty, your total savings becomes $1,250. This, for merely saving $5,000 in an IRA for traveling, which you needed to do anyhow.
Compared to other ways of trimming expenses or saving money during travel or a career break, using a traditional IRA is easy and highly effective, and represents savings that cannot be equaled by almost any other method. Setting up an IRA is quick and painless, and adding or withdrawing money from your IRA is easy to account for in your tax return.
For more detailed information on how to utilize a Traditional IRA to save money when planning long term travel, visit IRA Tax Savings for Career Breaks.