BY STEPHEN KYNE
We’re smack dab in the middle of tax season,
which means, for many of us, that we’re reviewing
what actions we could have taken last year to
improve our tax liability position.
Part of that review should include 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, how can you
know where best to save? Let’s review some basics.
Seed vs. Harvest:
All qualified retirement plans generally fall into
two categories for the purpose of taxation.
The first category includes those accounts
in which only the “seed” money is taxed, yet the
“harvest” grows tax-free. This is to say that only your
contributions are taxed, before being contributed
to the account, but everything those contributions
grow to become will be tax-free to you in retirement.
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
paramount concern.
The second category includes those accounts in
which the “seed” money is tax-free, but the “harvest”
grows to be fully-taxable when you withdraw
it in retirement. So, the upside is that you’ll get
a tax break on your contributions in the current
year, but everything those contributions grow to
become will be taxable to you in retirement as if it
was any other income.
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.
What’s the best plan for you? The answer is: it
depends.
The old paradigm 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.
Today, people are retiring and finding that they
want to do things with their time, and those things
cost money. The old paradigm is breaking down
as retirees spend 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.
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.
Rules of thumb: Contribution hierarchy:
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 taxfree
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 thumb 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 retired, the actions you take today will help
determine whether your assets will be available to
support you for your lifetime.
Photo Courtesy Sterling Manor Financial