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 fullytaxable
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 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 catchup)
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