Some parts of this blog were updated on March 14, 2018
It’s that time of the year again – tax time! It’s rarely anyone’s favorite time of the year. But what if this time, you approached taxes differently? What if you thought about taxes as a way to keep more of your money by actively managing them throughout the year?
Personal Capital’s 2017 Tax Series will give you ways to think about your taxes from a holistic financial point of view, as well as how to in the framework of your investments. From maxing out your retirement accounts and saving for college to tax-loss harvesting and asset allocation, it’s time to take control of your taxes in 2017 and beyond.
Retirement & Taxes
Despite the vital importance of retirement savings, many people tend to avoid the topic. For some, the date seems so distant. For others, the date is uncomfortably close, and they’re not sure if they’re on track. Throw in the possibility of early withdrawals, and retirement planning can feel complicated and, well, boring.
But it’s pretty tough to talk about retirement without considering taxes – when you save for retirement, you need to consider the tax treatment on those accounts.
Pretty much everyone has some basic knowledge about how a 401k works. Typically, this option is employer-sponsored, so the company provides an education about the available options, which can vary greatly.
The one-size-fits-all piece of advice for 401k participants is “employer-match” programs should be maxed out first—before considering any other retirement options. Why? Free money—who doesn’t like that. All 401k programs allow you to contribute pre-tax money, but employer-match programs require your employer to match the amount you contribute, up to certain limits. This means you avoid immediate taxes on the money you contribute and you get a matching bonus from your employer. Definitely a win-win.
The advantage of [Roth IRA] accounts is the tax-free distributions you’ll enjoy when you retire. This is particularly valuable if tax rates rise during the time your savings are growing.
Roth IRAs, traditional IRAs and Roth conversions are all options that offer you an opportunity to fine-tune your future retirement and to maximize your ultimate nest egg.
Simply put, a Roth IRA offers tax-free growth for your assets, tax-free distributions, and no required minimum distributions during the original account holder’s lifetime. The catch? You must make contributions from funds that have already been taxed. The advantage of these accounts is the tax-free distributions you’ll enjoy when you retire. This is particularly valuable if tax rates rise during the time your savings are growing. You will have already paid 2017 tax rates on the contributed money, so you don’t need to worry about the prevailing tax rate in 2027, 2037 or 2047. There are income limits to contributing to Roth IRAs, so make sure you are familiar with the phase-out rules before opening and contributing one (if you already participate in your employer’s 401k plan, there will be phase outs on deducting your IRA contributions).
If you just can’t imagine parting with already taxed income, there is a traditional IRA option. Contributions to traditional IRAs are tax deductible, you won’t pay taxes now, but you will owe ordinary income taxes on your withdrawals.
It’s All About Timing
While these options sound simple enough, lots of decision making based on current and future personal circumstances is recommended. For example, there is the option to do a Roth conversion, which converts a traditional IRA or a portion of your 401k, if allowed by your employer’s plan, to a Roth IRA. If you anticipate being in a higher tax bracket in retirement, then you may want to investigate this further – its tax- exempt nature amplifies compounding investment returns over time.
However, several criteria must be met before a Roth conversion makes sense, so make sure you do your homework on these before making any decision.
Before you can make an educated decision about which options are best for your future, you may also need to understand the nuances of terms like Net Unrealized Appreciation (NUA) – it’s a stock thing; and required minimum distribution (RMDs) – it’s an age thing.
Learn more about taxes and how they fit into your holistic financial life by reading our free Personal Capital Tax Guide for Holistic Financial Planning.
This blog is for informational purposes only; we are not in the business of providing tax or legal advice and we generally recommend seeking the advice and counsel of a tax professional before taking any action that may cause a material taxable event.
Amin Dabit, CFP®
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