Most of us chip in our share of taxes. That’s what we owe to our functioning society. But we also owe it to our hard-working selves and our plans for a comfortable retirement to boost the tax-efficiency of our portfolios at every possible turn.
One of the simplest ways to do this is to use tax-advantaged Individual Retirement Accounts (IRAs), which come in a variety of flavors, and to take full advantage of the rules as these accounts (hopefully) grow over time.
Here are a few things that most retirement-focused, tax-sensitive investors should consider:
Stash as Much as You Can. You can contribute up to $5,500 to a traditional IRA before tax day and the contribution can count in tax-year 2016. If you or your spouse participate in a retirement plan at work, the contribution could be tax-deductible, but there's a phase-out based on adjusted gross income. You and your spouse could each contribute up to $5,500, but you can only contribute to an IRA if you or your spouse has earned income.
The contribution jumps to $6,500 if you are age 50 or older because, at that age, investors can take advantage of the $1,000 IRA catch-up contribution. In fact, investors can make the catch-up and other IRA contributions right up to the filing deadline of April 18, 2016. This extended catch-up is one of the factors that differentiate IRAs from 401(k)s. That means, to max out IRA rules over the course of a year, you would need to contribute $458 per month, or $542 if you are age 50 or older.
Keep In Mind:If you have a workplace retirement plan as well, the tax deduction for Traditional IRA contributions is phased out for individuals with modified adjusted gross incomes between $61,000 and $71,000 in 2015 for those filing as single ($98,000 and $118,000 for couples filing jointly). If only one spouse has a retirement plan at work, the deduction is phased out if the couple's income is between $183,000 and $193,000.
Another No-Brainer: Catch Up a SIMPLE IRA. Self-employed retirement savers often use SIMPLE IRA plans. If you are under age 50, the tax-free contribution limit is $12,500 annually.
If you are age 50 or above you can contribute an additional $3,000 to a SIMPLE IRA for a total contribution of $15,500. Salary reduction contributions in a SIMPLE IRA plan are not treated as catch-up contributions until they exceed $12,500 in 2015. SIMPLE IRAs also allow for employer matching. So even as a self-employed saver, you could have your employer, in this case you, match up to 3%.
Other retirement plans available to self-employed savers include SEP IRAs and Individual(k)s, or Solo(k)s. Read more about plan ideas for self-employed retirement.
To Roth or Not to Roth? Good tax conversations around IRAs always eventually land at Traditional vs. Roth. Contribution limits for a Roth are the same as traditional retirement accounts, but the tax treatment is different.
Instead of getting a tax break when you make the contributions, Roth accounts allow you to pay the income tax at your current rate, which might be beneficial for younger savers and those in a lower tax bracket. The bonus? Withdrawals in retirement are tax-free. That may keep your nest padded at the crucial time you have to adjust to a new lifestyle and income source. Additionally, Roth IRAs offer tax-deferred growth leading up to withdrawals. And there's no required minimum distributions on Roth IRA until the death of the owner. Conversion to a Roth IRA may be particularly advantageous for people who have become self-employed or who have experienced a significant drop in income and, therefore, tax rates.
Keep in Mind: Eligibility to make Roth IRA contributions is phased out once an individual's income is between $116,000 and $131,000 in 2015 for those filing as single ($183,000 to $193,000 for couples filing jointly). But investors who earn more than the income cutoff may still be eligible to convert traditional IRA assets to a Roth. Investors can contribute to a traditional IRA and turn right around and convert that traditional IRA to a Roth IRA and pay the tax in the current year. An investor could potentially give up some of the tax benefit up front, depending on whether the initial deposit was made with pre-tax or after-tax dollars. If the deposit was after-tax, then only the gain is taxed as income on the conversion. Now, if you don't have excess cash on hand to pay the taxes, the conversion probably won't make sense.
Just Roll Over? If you've changed jobs this year, you have a decision to make about your 401(k) plan. You can cash it out, leave the assets in your former employer’s plan, roll it into a personal IRA, or roll it into your new employer’s 401(k) assuming one is available and still attractive. Think long and hard about ever cashing out though. You may be liable for taxes on the full amount, as well as penalties if you're under 59 1/2 years old.
A Place to Grow. Contributions to a Roth IRA are not tax deductible, as we know, but the capital gains on assets accumulate tax-free. That potentially makes it a good place to park growth-oriented assets. In a traditional IRA, the gains will ultimately be taxed as regular income when they're distributed.
Don’t Be Too Early (Or, Too Late). Traditional 401(k)s and IRAs have a variety of rules about “touch” and “no touch.” Withdrawals from traditional retirement accounts before age 59 1/2 typically result in a 10% early withdrawal penalty in addition to regular income tax on the amount withdrawn. However, there are some exceptions to the early withdrawal penalty if an IRA distribution is used for higher education costs, a first home purchase (up to $10,000), high medicals costs, or health insurance expenses after a period of unemployment. Most importantly, after you turn age 70 1/2, withdrawals from traditional retirement accounts are required. The penalty for missing a withdrawal is 50% of the amount that should have been withdrawn. Ouch—that miss will sting more than any tax bill ever did.
If you would like to learn more about which IRA might be right for you during tax season, and beyond, there is useful information and support that can help you pursue your retirement goals.
The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.