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Start Here: “The Ultimate Guide to Personal Finance”

Lots of answers about taxes and retirement from David Bergstein, CPA

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[Update]: David Bergstein edited his answer to #4 below.

Here is post 3 of 3 from David Bergstein, professional tax analyst and CPA. Below is an overview of how to think about taxes generally, then David’s answers to specific questions from iwillteachyoutoberich readers on this post.

See David’s previous posts here and here.

A special thanks for David and Mary at, who gave us not only these great posts and answers to specific questions, but also gave away 5 copies of their tax software at

* * *

Pulling it All Together and Keeping More of Your Money Working for You

By David Bergstein, CPA

It’s time for the last post in this series of how accumulating wealth requires you consider taxes. We started off discussing that “taxes are a fact of life” and then continued by stating that the only way for you to become rich is to “take responsibility for building your wealth” yourself by becoming financial literate as it relates to taxes and money. At this point it is time to look at what resources you have available to accumulate wealth.

Investments are an ideal way to accumulate wealth. The suggested types of investment, I will leave to Ramit to cover in more detail. Another important aspect of investment, though, is whether and to what extent your investment is something that produces taxes now or something that defers the tax on the gain until you are in a lower tax bracket. The younger you start to invest in an IRA or a 401K plan of one type or another, the sooner you start to accumulate tax-advantaged principal.

The first step is understanding what different types of 401K and IRAs you may want to consider, which depends on your income and your objectives.

A traditional IRA allows you to contribute up to $4,000 for the year 2006 and 2007 to an IRA account, with that money coming from pre-tax dollars, meaning you get to deduct it from your income for income tax purposes in the year you make the contribution. To be eligible for the tax benefits of a traditional IRA, single filers need to make under $52,000, with the benefit phasing out completely for those making $62,000 or more for 2007 (for 2006, the income limits are $50,000 phasing out at $60,000). If you’re married, then you need to make under $83,000, with the benefit phasing out completely for those making $103,000 or more for 2007 (for 2006, the income limits are $75,000 phasing out at $85,000).

There is also a Roth IRA, which has the same $4,000 contribution limit for 2006 and 2007. With this type of IRA you are not allowed a deduction from income but the money you invest will accumulate tax free. To be eligible for the tax benefits of a Roth IRA, single filers need to make under $99,000, with the benefit phasing out completely for those making $114,000 or more for 2007 (for 2006, the income limits are $95,000 phasing out at $110,000). If you’re married, then you need to make under $156,000, with the benefit phasing out completely for those making $166,000 or more for 2007 (for 2006, the income limits are $150,000 phasing out at $160,000).

The decision of which IRA is best depends on your income level and objectives: would you prefer to put in pre-tax dollars, and allow the income to grow tax-free, paying taxes only as you withdraw funds during retirement? If so, then a traditional IRA is more likely the route to choose. If, though, you’d prefer to pay taxes now, let the funds grow tax free but then have to pay taxes on the interest income when you’re in retirement, then the Roth IRA is worth considering.

There’s no right or wrong answer and, in some instances, individuals choose to contribute to both types of IRAs over the course of their lifetime. In both cases you accumulate wealth and principal through tax-advantaged investing.

One word of warning, though: The ultimate goal of IRAs is to save for retirement, so there are generally taxes and penalties assessed for early withdrawal. But there are ways to take money out early without penalties, for example, up to $10,000 can be withdraw for buying your first home.

If you are working for an enterprise that has a 401K plan (or a 457 or 403(b), which are similar types of saving programs) then you have additional tax-advantaged saving choices, which don’t limit your investments based on income.

Investments take many forms and contributions to a retirement plans are only among a few of the choices. There are many other choices including investing money in the bank or bonds, earning interest that is either taxed or tax exempt or investing in stocks that appreciate or pay dividends or, better yet, both. If you hold stock for over a year it is considered long term and the tax rate is lower for long-term gains than it is for short-term gains. So another principal of accumulating wealth is being patient, and knowing how to off-set gains with losses for tax benefits.

Investing in real estate is another choice and renting it out another. Investing in rental property yields a double benefit if you do it wisely. It appreciates and it produces a positive cash flow through rent. Additionally, it can produce a tax loss because you can depreciate the property over its estimated useful life.

I can go on and on with different scenarios but you should make it a practice to regularly read up on the different vehicles or places to invest your money. Ramit’s blog is a great resource as is regularly reading financial papers like the Wall Street Journal. To learn about specific tax benefits of each choice you can consult a tax guide either in print or if you prefer, CompleteTax has a free guide at

Hopefully these columns on taxes have started a number of you on the road to financial wealth as it relates to taxes. Minimizing your tax liabilities and accumulating wealth is hard work and involves planning so take the time to do the reading and studying. It will reap benefits as your assets accumulate.

Now, let’s address a few specific questions submitted on taxes on investments as well as taxes related to marriage, education and charitable donations.

Question 4. Even though retirement is a long way off, I would like to know how the IRAs – traditional and Roth would be taxed when taking the distribution. If you could write about this and other tax related information with regard to capital gains all your readers would greatly benefit.

Posted by JM at March 23rd, 2007 at 8:42 am

ANSWER (EDITED BY DAVID BERGSTEIN FROM FIRST POSTING): I’ve addressed this in detail above, but the basic difference is that you would use pre-tax dollars to fund a traditional IRA (assuming you meet the income requirements) and the dollars – both the amount you invested and any interest earned – would then be taxed upon distribution at retirement. With a Roth IRA you would use after-tax dollars. Those dollars would not be taxed (again) upon distribution, but any interest would be taxed.

Question 112. Could you give a general explanation of how various retirement account contributions (in Roth IRA vs. Traditional IRA vs. 401(k) vs. 403(b)) affect tax filing? Which have deductible contributions and which factors are considered in eligibility requirements for those that do?

Answer: A 401K is a plan that is generally established by a profit-making entity whereas a 403(b) is established by a non-profit entity, such as a church, public school, etc. From the IRS site,,id=108942,00.html: “With a 401(k) plan, employees can choose to defer some of their salary. So instead of receiving that amount in their paycheck, the employee defers, or delays, getting that money. In this case, their deferred money is going into a 401(k) plan sponsored by their employer. This deferred money generally does not get taxed by the federal government or by most state governments until it is distributed….Basically, 403(b) plans are similar to 401(k) plans maintained by for-profit entities. Just as with a 401(k) plan, a 403(b) plan lets employees defer some of their salary. In this case, their deferred money goes to a 403(b) plan sponsored by the employer. This deferred money generally does not get taxed by the federal government or by most state governments until distributed.”

With both, you can contribute as much as $15,500 for 2007 ($15,000 for 2006) as well as an additional $5,000 if you are over 50 years old. Your contribution is made with pre-tax dollars if you use a traditional 401(k) or 403(b) plan. If you use a Roth version of these plans, then your contribution is made with after-tax dollars.

Question 118. If I start an IRA for myself and my wife can I subtract that from our adjusted gross income and pay a lower tax rate?

Posted by Marshall Middle at March 29th, 2007 at 5:43 am

Answer: There’s no easy answer to this. It depends on several factors, including your joint income, contributions you’ve made to other retirement plans and your age. Some information on the rules and tables that may help you is accessible at

Question 43. I did a 401(k) rollover this year. I got a 1099-R form for the distribution, but no paperwork for putting it back in. Should I have? If not, how do I show that I shouldn’t be taxed on this distribution?

The funds were from different employers, but the fund manager is the same for both.

Posted by Dustin L. at March 15th, 2007 at 10:19 am

Answer: Smart move on your part to rollover. But it sounds like you took possession of the funds for a period of time as you indicate you put it back in. Generally, the best approach is to do a direct rollover of any money in retirement plans because if you don’t have it rolled over into the new retirement account within 60 days you will have to pay a tax and a 10% penalty on top of that. If you had done a direct rollover your 1099-R would have a distribution code in Box 7, which would be the letter G. If you did not do a direct rollover then the 1099-R would have a different distribution code in Box 7, which is explained on the back of the 1099-R. So you do not need additional paperwork.

Question 47. For 2005, I was employed at 12.48/hr from 1/1-3/31; unemployed from 3/31-7/31, employed at 32k/year from 7/31 to present. My son lives with my sister in another state, but I pay his college tuition. I am also a student, but the Dept. of Labor pays mine. How do I file; can I take a credit/deduction for his tuition? How do you maximize donations?

Posted by Carol at March 15th, 2007 at 12:11 pm

Answer: Wow. You’ve got a lot going on. There are a number of different education deductions and credits that you may be eligible to take related to paying your son’s tuition, assuming you claim him as a dependent on your income tax. You can read more about these at However, if you do not claim him as a dependent – either because your sister or another family member does so, or because he is no longer a dependent, then you won’t be able to take any of the deductions or credits. As for your question on donations, the rules have tightened, so it’s all the more important to keep records of your donations. For example, you must have receipts for any property donated that’s valued at more than $250; starting for 2007, all cash contributions of any amount must be substantiated. Also as of August 18, 2006, generally household items or clothing that are not in good used condition can not be deducted.

Question 13. I’ll be getting married this year. Is there anything I should do this year to minimize next year’s tax payments?

Posted by AJ at March 14th, 2007 at 5:22 pm

Answer: Congratulations. One thing you should do is change your W-4 form to reflect that you are married if necessary. The reason I say “if necessary” is because I’m assuming you and your spouse will now file a joint return which will have to take into account both of your incomes and deductions. Generally speaking, it’s advantageous for most married couples to file jointly. There is a W-4 calculator located at Another consideration – though many couples shy away from it – is to draft a prenuptial agreement. No one likes to discuss the end before the start, but the reality is that divorce is costly. So, particularly if you have significant assets already or expect to accumulate or inherit significant assets, it’s worth considering such an agreement.

From Ramit: If you’re interested in learning more about retirement accounts, read my previous post, The World’s Easiest Guide to Understanding Retirement Accounts

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  1. I believe that the answer to question number 4 is partially incorrect. A Roth IRA has a tax structure unlike that of any other IRA: contributions are post-tax, but growth is tax-free; once you put your money in, you never pay taxes again.

    Since withdrawals are not reportable income, they won’t affect your adjusted gross income during retirement.

  2. Wow, didn’t really expect to see my question come up. Thanks for the answer and the help! On the wild chance that there’s anyone out there with a similar situation, what wound up happening is: I didn’t have enough charitable contributions to outweigh the standard deduction, but then my sister allowed me to claim my son, so I was able to “recoup” some of the tuition costs. Oh, yes, and I’m taking “Tax Accounting for Individuals” this quarter! Oh, I do push him to apply for scholarships; I just don’t get why “kids” (I’m only 38) don’t want to even try for them. It’s really not that hard.
    Thanks again for the advice and the great blog!

  3. I also believe the answer to number 4 is partially incorrect. Changes may be made to the Roth IRA rules in the future but right now all contributions, including earnings, are tax free.

  4. so what about if you make more money than the traditional IRA will give you a tax benefit for, and also beyond the salary range eligible for a roth ira, how would one use an IRA to help in addition to 401(k)

    any help?

  5. Per IRS Publication 590:

    “You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s). You also do not include distributions from your Roth IRA that you roll over tax free into another Roth IRA. You may have to include part of other distributions in your income. See Ordering Rules for Distributions, later.”

    Of particular interest is “or distributions that are a return of your regular contributions from your Roth IRA(s).” There are some cases where contributions are treated different from earnings, but they are the exception rather than the rule. It’s disconcerting that a CPA and professional tax analyst would make either an incorrect or, at best, ambiguous statement on such an important retirement vehicle.

  6. David Bergstein Link to this comment

    JM, you are correct. Let me elaborate on the rules. With a Roth IRA you make contributions using after tax dollars. Qualified distributions from a Roth IRA are not included in your gross income. Qualified distributions need to satisfy a five-year holding period and meet one of four additional requirements. These are that the distribution is: made on or after the date you reach the age of 59½; made to a beneficiary after your death; attributable to you being disabled; or due to a qualified special purpose distribution.

  7. There’s a note posted on question 4 hinting that the CPA’s statement of taxing interest on Roth IRAs is completely wrong, but he also repeats that wrong point further up on the page:

    “If, though, you’d prefer to pay taxes now, let the funds grow tax free but then have to pay taxes on the interest income when you’re in retirement, then the Roth IRA is worth considering.”

    Personally, I’d prefer to pay taxes now, let the funds grow tax free, and then NOT have to pay taxes on the interest income when I’m in retirement. That’s why I have a Roth IRA, not a Bergstein IRA.

  8. Good article. One thing that I always wonder is should you max out on 401k or Roth? e.g. My company will match 3% of my salary. I currently invest 10% but come up short a bit in my max. Roth contributions. Does it make more sense to max the Roth and back off the 401k since I am beyond the company match? I know the quick answer is to keep 10 in the 401k and find a way to max the roth, but I’m still getting there. Every time I get a raise, I try to put a piece retirement before I get used to the extra cash.

  9. Derek,

    Put enough in your 401k to get the full company match.

    Then max out your Roth.

    Then, put whatever else you have available to save towards your 401k.

  10. To Derek,

    I would say, first max your company matched portion to your 401k (seems like 3%)

    Then max your Roth.

    Then put the rest in the 401k.

    That’s the rec I’ve seen time and time again. And think of it this way, your unmatched portion behaves much like your roth. But your Roth is tax free in the end, better to put money in the roth than the unmatched portion of your 401k.