Tuesday, December 14, 2010

Best Money Move During a Payroll Tax Holiday

Congress is getting close to a deal that would, among other things, create a one year payroll tax holiday for all workers.  This 2% tax break means that someone earning $70,000 could add about $1400 a year to their take home pay.

The government is hoping this money will be used to consume more goods and services, jump starting the economy.  But you're reading an investing blog, so you're probably more interested saving and investing this "free" money.  What is the best way to do so?  Tax advantaged accounts.

By taking home a larger paycheck without an increase in gross pay, your dollars are "cheaper" now than they were before.  The best way to juice returns on these dollars is to invest them in a 401(k), Traditional IRA, or Roth IRA.  In doing so, you win twice, once in your paycheck, and again in your deferred gains / taxes.

For example, say you invest that money in your 401(k).  Since contributions are from pre-tax dollars, you lower the taxable portion of your paycheck.  You will be paying less in taxes on a smaller amount of money!  

Another option is to contribute that money into a Roth IRA.  Roth contributions can be withdrawn tax free after age 59 1/2, and if you think taxes will be higher in the future (I hear a resounding yes...) you are using cheaper dollars now to buy more expensive dollars in retirement.

More important than how you save is simply that you do save.  You managed to live in 2010 on a budget 2% less than you'll be making in 2011.  It's free money.  Set up your accounts to invest it automatically, and you'll never miss it.

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