Everyone has heard the old adage that the only free lunch in finance is diversification. Having a diverse asset allocation in one’s investment portfolio is a pillar of a successful retirement plan. We would argue that tax diversification in the accounts that one is saving for retirement is also critically important to a sound retirement plan. Having multiple buckets to pull from can help in tax planning as well as if an unforeseen emergency should strike.
The Bedell Frazier Financial Planning Department has put together a retirement account saving diversification playbook. This tool can be of assistance whether you have just started your first job out of college or if you are in your late career counting down the days until retirement. For those who are nearing or in retirement, we will share with you some insights on taking money out of your retirement accounts.
Types of Retirement Savings Accounts:
We will start with the 401k as this is the most common retirement account. You may be offered a 401k plan through your employer if they are a for-profit company. If they offer a company match, this is the first place you will want to allocate retirement savings dollars. For example, your company’s plan may match up to 3 percent of your salary or 50 cents on the Dollar up to 8 percent of your salary. The company match is free money toward your retirement savings.
Another advantage is that 401k contributions are made on a pre-tax basis lowering your taxable income for the year. The money is usually invested in a mix of mutual funds and exchange-traded funds, however some plans allow individual securities. The Bedell Frazier Financial Planning team can help you or your children with their 401k asset allocation.
The maximum contribution to a 401k is $22,500 or 100% of your compensation, whichever is less. If you are age 50 and older, you get a “catch-up” contribution of $7,500 for a total of $30,000. If you want to contribute to the over 50 “catch-up” bucket you may have to indicate an additional withholding, so be sure to check with your 401k provider.
Retirement Game Plan: If your plan allows, you may be able to access your 401k savings at age 59.5 penalty-free if you are focused on early retirement. The growth of the investments over time is tax-deferred, which is a fantastic wealth accumulation tool. A 401k is subject to required minimum distributions (RMD) which is when you have to start taking withdrawals every year. The current age at which required minimum distributions begin mandatory distributions is age 73, and the withdrawals are taxed as ordinary income. There can be some tremendous financial planning opportunities in the years between the time you retire and are no longer receiving paycheck income and begin the ordinary income generated by your required minimum distributions.
Similar to a 401k, a 403(b) is a tax-advantaged retirement plan but for non-profit organizations and some public-sector workers like teachers. The investment options are limited to mutual funds and annuities for most plans.
A 457 plan is a tax-advantaged retirement plan primarily for state and local government employees, like municipal employees and civil servants. In addition, some charities have 457 plans for their employees.
There are several tax incentives associated with traditional Individual Retirement Accounts (IRA). If you or your spouse don’t have a retirement plan through your employer, like a 401k, the contributions you make to a traditional IRA are usually tax-deductible. If you or your spouse have a retirement plan at work, the amount that is tax deductible is subject to income limits.
In 2023, the maximum IRA contribution is $6,500 or 100% of your earned income, whichever is less. If you are age 50 or older, you can add a “catch-up” contribution of $1,000. Note that a non-working individual can use their spouse’s earned income to qualify to contribute to an IRA.
Even if you don’t qualify for a tax-deductible IRA contribution, you can still make an after-tax contribution to a traditional IRA. If you leave your current job, you can roll your 401k over into a Rollover IRA.
Retirement Game Plan: When you reach the age of 73, required minimum distributions begin on a traditional IRA with the distributions taxed as ordinary income, except any after-tax contributions which are not taxed. The penalty is big if you miss your RMD, 25% of the amount not withdrawn. It is imperative to understand the rules surrounding drawing down your retirement accounts. Even if you don’t need the RMD for living expenses, make sure the funds are withdrawn and reinvested in a non-retirement account. Another option is to gift the money to charity directly from the IRA by using a Qualified Charitable Donation (QCD), no taxes are due on distributions made via a QCD.
You could choose to make your annual IRA contribution to a Roth IRA. This is one of the most attractive retirement accounts available because the money grows inside the account tax-free, and there are no taxes on withdrawals. There are also no required minimum distributions with a Roth IRA. There are income thresholds that limit who may contribute directly to a Roth IRA. For 2023, the phase-out range for Roth contributions for adjusted gross income is $138,000 – $153,000 if single or $218,000 – $228,000 if married filing jointly.
Retirement Game Plan: There are no taxes on withdrawals, so the Roth IRA is a great emergency fund bucket in retirement (use our Emergency Fund Calculator here). If you need to pay for a major expense, you won’t also have the associated tax bill from the tax-deferred account, such as in an IRA or 401k. Another key advantage of a Roth IRA is that there are no required minimum distributions. That means you can keep the money growing tax-free for your entire life. This is what makes Roth IRAs a popular choice for families looking to preserve generational wealth. The account can grow tax-free, and the owner can pass it on to the next generation with no income tax burden to the recipient. With the passage of the SECURE Act, the Roth IRA passed on to a child can grow tax-free another ten years before any withdrawals need to be taken.
Above the Roth IRA limits?
There are other ways to get money into a Roth IRA if you are above the income contribution limits.
Contribute and Convert
If you do not have a Traditional IRA account, you may be able to utilize a strategy called a back door Roth where you contribute after-tax dollars to a Traditional IRA (no tax deduction) and then convert those tax-free into a Roth IRA. As long as you have no other IRA accounts, the conversion of the contribution is tax-free. The Build, Back, Better legislation passed in the House of Representatives but never came to a vote in the Senate. The Back Door Roth has been in legislators’ crosshairs for many years but is still an effective strategy in 2023.
Another way to get dollars into a Roth account is by doing a Roth Conversion. You take a distribution from your current IRA or 401k and roll it into a Roth account. You pay taxes on that distribution in the current tax year while creating a Roth tax-free bucket for the remainder of your life (under current tax law). The conversion is not limited to the $6,500 contribution limit, you can convert as much as makes sense based on your other taxable income and time horizon. A great time to execute this strategy is when you are in that “income valley” between having paycheck income and taking the required minimum distributions from your retirement accounts. We can model this in our financial planning software for you if you are interested in learning more.
With a Roth 401k, your contributions are after-tax dollars rather than pre-tax dollars, but when you make withdrawals in retirement, they are tax-free. The Roth 401k offers the combination of tax-free growth and tax-free withdrawals in retirement.
Retirement Game Plan: With the passage of the Secure Act 2 in December of 2022, there are no required minimum distributions (RMD) from Roth 401ks starting in 2024, the withdrawals are tax-free. This sets up some tax diversification in your retirement withdrawals, just as you diversify your investment portfolio, you should also consider diversifying your tax liability. Many investors have a disproportionate amount of their wealth tied up in tax-deferred accounts such as traditional IRAs and 401k.
Self-Employed Retirement Plans
The type of account that works best for each person depends on a number of variables, including their net income, age, and if they have employees or a spouse working in the business. The Bedell Frazier Financial Planning Department and your tax professional can provide additional information and guidance based on your unique circumstances.
Types of Self-Employed Retirement Plans
Small business owners can open a SIMPLE (Savings Incentive Match Plan for Employees) IRA if they don’t have another retirement plan in place. Under a SIMPLE IRA, contributions made can be deducted by the business, and all employees’ contributions are immediately vested.
The employee contribution limits for 2023 are $15,500 a year to a SIMPLE IRA with a 50 or older catch-up contribution of $3,500. Employers must make contributions for each of their employees, either dollar-for-dollar matching contributions equal up to 3% of their employee’s salary, or a non-elective contribution of 2% of the employee’s salary, whether or not they contribute to the SIMPLE IRA.
Another option for business owners is a Simplified Employee Pension or SEP IRA. The main advantage of the SEP IRA is the much higher contribution limit than a regular IRA account, up to $66,000 in 2023.
Only employers can make contributions to a SEP IRA. If the business owner is contributing to their own SEP IRA, they must contribute the same percentage to all your employees’ SEP IRAs. For 2023, the employer may contribute up to 25% of an employee’s compensation or $66,000, whichever is less.
A solo 401k is a good choice for those who are self-employed with no other employees, except maybe a spouse who works part-time. As with other 401k accounts, you can have a traditional Solo 401k or a Roth Solo 401k.
A great feature of a Solo 401k is the ability to make contributions to the account as both an employer and an employee. You get the standard $22,500 with the $7,500 catch-up as an employee and as the employer contributes 25% of your compensation. In 2022, the total contributions cannot exceed $66,000, or $73,500 if you are 50 or above.
Finally, you should have money saved in a taxable account for retirement, whether that is an individual account, joint account, or trust. You will pay taxes on dividends, interest, and capital gains on this taxable account each year. The upside is huge with the flexibility of being able to pull from a taxable account without paying ordinary income taxes, as is the cash for withdrawals from 401k or IRA. Tax flexibility is extremely important in retirement.
An emergency fund should also be part of your taxable account savings. You want to have at least three-to-six months of non-discretionary expenses set aside to be prepared for unforeseen circumstances that may arise (Use our Emergency Fund Calculator). We see too many people that have their retirement wealth tied up in tax-deferred accounts that are susceptible to incurring a large tax bill if they have to pull money out to fix a roof or pay for large car repairs. The key with this emergency backstop is you won’t have to put expenses on high-interest credit cards or pull money out of retirement accounts, which could result in early withdrawal penalties as well as taxes.
There are many factors that contribute to selecting the proper retirement account to fund during your working years. This year, make a resolution around your financial improvement, a resolution that will serve you well! Contact the Bedell Frazier Financial Planning Department for tips on how to get started saving for retirement or if you need a financial plan for spending with confidence in retirement. We can assist you wherever you are in your career path with the goal of heading toward financial freedom.