When Planning for Retirement, Taxes Matter

When Planning for Retirement, Taxes Matter

It’s not just what your investments earn that’s important – it’s what you keep.

So how can you minimize taxes while saving for retirement? There are plenty of options, depending on your employment status, income and other factors.

It used to be simple. Employees worked, typically to age 65, then received pension benefits from their employer, which supplemented their Social Security benefits and personal savings. But traditional defined benefit pension plans became impractical as retirees began living longer and employees began working multiple jobs over their lifetime.

Today, employees most often have a defined contribution retirement plan, such as a 401(k) plan, which allows them to determine how much to contribute to retirement and how it will be invested. They can also invest in various types of IRAs, as well as annuities.

What’s Right for You?

Which approach, or combination of retirement plans, is right for you? Much depends on what is available to you through your employer, but other factors, such as age and financial goals, also should figure into your retirement planning.

Employer-sponsored plans. Financial experts typically recommend that employees take advantage of employer-sponsored plans to the extent possible, contributing the maximum amount to their 401(k) plan, 403(b) plan or whatever qualified plan the employer offers.

That’s because such plans offer tax advantages and employers match contributions. Employer matches vary, but 42% of companies match employee contributions dollar-for-dollar. Before 2013, the most common match was 50 cents for every dollar contributed by the employee. A majority of plans require workers to contribute at least 6% of their income to be eligible for the full matching contribution.

Some employers offer a choice between a traditional 401(k) plan and a Roth 401(k), which offer distinctly different tax advantages. With a traditional 401(k) plan, contributions are tax deductible and investors can defer taxes on earnings from their investments until they begin taking distributions.

Because earnings accumulate untaxed, total returns should be higher. And as income is typically lower during retirement years, taxes should be lower, as retirees typically will qualify for a lower tax rate.

Those who choose a Roth 401(k) pay taxes on their initial contributions, but never have to pay taxes on the account’s earnings, as long as the assets are held in the Roth IRA for at least five years and the owner is 59½ or older before taking any distributions.

The younger you are, the more attractive the Roth approach may be, because earnings will have more time to accumulate tax-free. Having at least part of your retirement savings in a Roth plan will also provide an opportunity for you to reduce your taxable income during retirement, which can make you eligible for a lower tax bracket.

Qualifying employees can contribute up to $18,000 a year to a 401(k) or comparable plan, while those aged 50 and older can contribute an additional $6,000. Funds withdrawn from a traditional or Roth 401(k) plan before age 59½ are subject to a 10% penalty.

Employees can contribute to both Roth and traditional 401(k) plans, as long as the combined contributions do not exceed the contribution limits.

IRAs. There are several varieties of individual retirement arrangements or IRAs. Like 401(k) plans, there are traditional IRAs and Roth IRAs. There are also SEP-IRAs, which are used by self-employed individuals and small businesses, and self-directed IRAs, which enable individuals to invest in alternative assets, such as real estate, private equity and precious metals.

Both traditional and Roth IRAs allow contributions of $5,500 per person, per year for the 2017 tax year, plus an additional $1,000 catch-up contribution for those over age 50. Those who have SEP-IRAs, though, can contribute up to $54,000 this year.

Traditional IRAs, like traditional 401(k) plans, allow taxpayers to defer taxes on their earnings until they take distributions, regardless of their overall income. Also, like 401(k) plans, they can deduct contributions from their income, lowering their taxes, but only if they meet income guidelines.

Taxpayers who do not have a retirement plan through an employer or a spouse can deduct IRA contributions regardless of income. If your spouse has a retirement plan through an employer and you file jointly, the ability to deduct taxes for IRA contributions phases out when your taxable income is between $186,000 and $196,000.

For all others, the ability to deduct contributions phases out for individuals earning $62,000 to $72,000 in taxable income, and for married couples filing jointly and earning $99,000 to $119,000.

As with Roth 401(k) plans, taxes on Roth IRA contributions are paid up front; earnings are never taxed. Roth IRA eligibility begins to phase out for single taxpayers when they earn more than $118,000. They can make partial contributions until they reach the income limit of $133,000. For married couples, eligibility begins to phase out when their joint income reaches $186,000, and they can make partial contributions unless their income exceeds $196,000.

The income guidelines are meaningless, though, because taxpayers who fail to meet them can invest in traditional IRAs and then convert them to Roth IRAs.

While owners of traditional IRAs must begin taking distributions by age 70½, there is no mandatory withdrawal requirement for Roth IRAs. Roth IRA owners can even pass their Roth assets on to beneficiaries income-tax free. Beneficiaries of traditional IRAs are taxed on the accumulated income.

While Roth IRA income is subject to federal estate taxes when it is inherited, surviving spouses can roll the money into their own Roth IRAs. Other beneficiaries can receive distributions throughout their lifetime if distributions begin no later than December 31 of the year following the year of the owner’s death. Otherwise, they can keep assets in the Roth IRA for up to five years after the original owner’s death before withdrawing them in a lump sum.

Funds can be withdrawn without penalty from traditional and Roth 401(k) plans, and traditional and Roth IRAs when there is a disability or death, or when individuals are over age 59½, although funds in a Roth IRA must be held for at least five years. Funds converted from traditional IRAs may be withdrawn tax free, but may be subject to penalties if the money is withdrawn within five years of the conversion.

Annuities. The advantage of an annuity is that, like Social Security, it can provide you with income no matter how long you live.

The money you’ve invested in a 401(k) plan or IRA can run out. An annuity is a tax-deferred-accumulation contract in which the buyer contributes a lump sum or series of payments and, in return, can receive regular payments for life.

Investors can choose between fixed annuities, which provide a guaranteed principal and a guaranteed return, and variable annuities, in which the value fluctuates based on the performance of the underlying investment accounts. The guaranteed principal and return from a fixed annuity are based on the claims-paying ability of the issuer.

Payouts from fixed annuities do not change over time and, therefore, do not keep pace with inflation. Using variable annuities, investors can allocate their funds to equity-based or bond-based investments with a wide range of risk and potential return.

While past performance is not necessarily indicative of future performance, variable annuities have the potential to keep pace with or exceed the rate of inflation. However, fees are often high and variable annuities may carry surrender fees.

Like qualified retirement plans, taxes are deferred on any growth within annuity accounts. Earnings withdrawn are subject to taxation and, prior to age 59½, may be subject to a 10% IRS penalty. Unlike many retirement plans, there are generally no limits on the amount of money that can be invested in annuities and many variable annuities even offer death benefits.

Which retirement plan options are right for you depends on availability, eligibility, your age, your income and other factors. In most cases, it’s worth considering a variety of options to ensure that your money will be available when you need it.

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