It’s the time of year when many people sit down with various degrees of trepidation and being to prepare their annual tax return. Ultimately, once the results are revealed, the question becomes, “what could I have done differently last year to decrease this bill?” Managing your tax liability today, and creating a taxwise strategy for accessing funds in retirement, begins with a basic understanding of the savings vehicles which are available to you, and the ways in which they are taxed.
All qualified retirement plans generally fall into two categories for the purpose of taxation.
The first category includes those accounts in which you’ll get a tax break on your contributions, but everything those contributions grow to become will be taxable to you as if it was any other income in retirement. In other words, the “seed” money is tax-free, but the “harvest” grows to be fully-taxable when you withdraw it in retirement. We call these tax-deferred accounts. These accounts include Traditional IRAs, 401(k)s, 403(b)s, SEPs, SIMPLE IRAs, 457 Deferred Compensation plans – generally the non-Roth plans available to you through your employer. These accounts are useful for lowering your tax bill in the current year, but won’t be very helpful for controlling taxes in retirement.
The second category includes those accounts in which only your contributions are taxed, before being contributed, but everything those contributions grow to become will be tax-free to you in retirement. In other words, only the “seed” money is taxed, yet the entire “harvest” grows tax-free. These accounts include a Roth IRA, Roth 403(b) and Roth 401(k) – the word “Roth” should be your clue. These types of accounts won’t generally reduce your tax liability today but, since you have tax-free access to the growth in retirement, they can go a long way to reduce your future tax liability at a time when making your assets last will be your biggest concern.
It’s important to remember that diversification doesn’t just mean a mixture of types of stocks and bonds anymore, it is equally important to diversify the way your retirement income will be taxed in order to have more control over your tax liability in retirement, to help ensure your retirement assets last a lifetime. Contributing to a mixture of retirement accounts can help accomplish this goal. It may be tempting to forego the future tax savings of Roth-type accounts, for the immediate tax deduction available through non-Retirement accounts, but it is important to have a sense of balance.
Here are some general rules of thumb to keep in mind when saving your hard-earned dollars:
1. If your employer offers you a match on retirement plan contributions, always try to contribute to the match. For example, if your employer will match your contributions up to 3 percent of your salary, try to contribute 3 percent. Regardless of the taxation in this account, where else will you be able to double the value of your contribution in one year? Take the free money.
2. Once you’ve contributedto the match, contribute to a Roth IRA if you’re eligible. Your contributions to a Roth IRA can be up to $5,500 with an extra $1,000 as a catch-up contribution if you’re over age 50. Contribution limits are more restricted for Roth IRAs because the impact of tax-free growth is so high. In short, the growth is money the government won’t be taxing in the future, so it’s in the interest of the government to limit how much you can contribute.
3. If you’ve contributed to the match in your employer-sponsored plan, and you’ve maximized your eligible Roth IRA contributions, then you should consider contributing more to your employer-sponsored tax-deferred plan. Contribution limits range from $12,500 (with a $3,000 catch-up) for SIMPLE plans, to $18,500 (with a $6,000 catch-up) for 401(k)s, 403(b)s, 457 Deferred Compensation plans, SARSEPs. Certain plans could even accept contributions of more than $200,000
4. If your employer offers Roth and non-Roth retirement plan options, consider making a portion of your contributions into each type, if possible. This will help give you the benefits of both, and more choice in the future.
Of course, these are just guides, so consult with your independent financial advisor and tax advisor during one of your regular strategy meetings to determine the balance that’s right for you. Having the option to choose between tax-free and taxable income in retirement might make the difference between whether or not your retirement will be sustainable.
Don’t let another tax year go by without taking control!
Stephen Kyne is a Partner at Sterling Manor Financial, LLC in Saratoga Springs, and Rhinebeck.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.