It’s tax season again! Unless you’re expecting a large refund, or you’re an accountant, you’re probably not really that excited about this time of year. For many of us, though, this is when we can review what actions we could be taking to improve our tax liability position today and in the future. One of the biggest things we can do to impact our tax liability is to take a look at your retirement savings contributions and how they are treated for tax purposes. With so many different types of retirement accounts out there, it can be confusing to know just where to save. Let’s cover some basics.
All qualified retirement plans generally fall into two categories for the purpose of taxation.
The first 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. Conceptually, I like to think of it this way: 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.
The second 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. Or, 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.
So, where’s the best place to put your savings? The answer is, it depends.
The old way of thinking was that people would spend less money in retirement, therefore they would be in a lower tax bracket, meaning that tax-deferred accounts would be more beneficial since you get a tax break on the contributions and the withdrawals would be taxed at, assumedly, a lower rate.
That sort of thinking is starting to break down as, today, people are retiring and finding that they want to do things with their new-found time, and those things cost money. Retirees are spending more time and money traveling, buying “toys”, and generally enjoying themselves. Many are finding themselves in the same or higher tax bracket in retirement, meaning tax-deferred accounts are being hit hard by taxes.
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 as long as you do! Contributing to a mixture of retirement accounts can help accomplish this goal.
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 contributed to 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 $18,000 (with a $6,000 catch-up) for 401(k)s, 403(b)s, 457 Deferred Compensation plans, SARSEPs. Certain plans could even accept contributions as high as $210,000!
Of course, these are just rules of thumbs — guides- and you should be working closely with your financial advisor and tax advisor to determine the most effective way to save for your retirement while maximizing and balancing tax-efficiency for today, and keeping an eye on your needs in the future. Once you’ve retired, and stopped earning an income, the actions you take today will help determine whether your assets will be available to support you for your lifetime.
Stephen Kyne is a Partner at Sterling Manor Financial, with offices in Saratoga Springs and Rhinebeck and can be reached at 518-583-4040.
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 and Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.