There are many opportunities to save for retirement while enjoying some tax benefits, and taking advantage of them – at least partially – is a good idea for everyone at any income level. Whether or not you should maximize your savings depends on both your circumstances and the savings plan.
What to pay first
It doesn’t make sense to save for tax benefits in retirement if you have not taken care of these important expenses first:
- Have 3 to 6 months of living expenses in a liquid account, in case of emergencies
- Pay down all credit card debt and any loans with high interest rates
- Budget savings for short-term goals (buying house, college savings for children)
- Hold sufficient life insurance, health insurance, and long-term care insurance (if over 55)
If these important expenses and all necessary costs of living are covered, consider the options that are best for you to save for retirement. You may contribute to several different kinds of retirement accounts in order to get the most benefit.
IRAs come in different forms, and which one is best for you depends on your income and tax bracket.
- Traditional IRA: Traditional IRAs allow funds to be invested before taxes and accrue interest tax-deferred. Taxes are paid upon withdrawal. For those with income below $62,000 if single or $99,000 if married filing jointly, an individual can contribute up to $5,500 per year ($6,500 if 50 or older). Beyond this income level, contribution limits decrease until an income level of $73,000 if single or $121,000 if married filing jointly. Above these income levels, contributions are not permitted.
- Roth IRA: The Roth IRA investments are made with after-tax dollars, but no taxes are paid upon withdrawal. This is a better option for those who expect to be in a higher tax bracket by the time they retire. Contribution levels are the same, but they allow people with higher incomes to contribute: $118,000 if single, $186,000 if married filing jointly. Like the traditional IRA, contribution limits drop until the maximum allowable income: $133,000 and $196,000, respectively. You may split your contribution between both types of IRA.
- The so-called Backdoor IRA: This is an option for high-income earners who want the tax advantage of a Roth IRA. Basically, you are able to rollover existing IRA or 401(k) funds into a Roth IRA, paying the taxes now, but benefiting from continued tax-free growth and tax-free withdrawal later. There are many details about this strategy that can be beneficial, but it’s important to talk to your tax advisor.
- Employee-sponsored 401(k): Contributions to a 401(k) have no income limit and have a high contribution limit: $18,500 if single, $24,000 if married filing jointly. In addition, employers often contribute some portion to their employees’ 401(k) accounts, so that’s free money. Consider before maximizing this account, however, what kinds of investment options you have within the 401(k) and what the fees are.
Options for the self-employed
If you’re self-employed, you have several options besides the IRA opportunities listed above.
- Solo 401(k): There are both traditional 401(k)s and Roth 401(k)s with the same tax benefits as described in the IRA versions. However, 401(k)s have no income maximum, and you benefit from both the employee and employer contribution opportunities. As an employee of yourself, you can contribute the $18,500 or $24,000 as described above, but you can also contribute up to 25% of your earned income.
- SEP IRA: The Simplified Employee Pension IRA is for small businesses with 5 or fewer employees. Only the employer contributes to this, not employees, and if you have employees, you must contribute to theirs when you contribute to your own. If you are a freelancer or self-employed, you are your only employee. You can contribute up to 25% of your earned income to a maximum of $55,000 in 2018.
Get help with the details
It’s important to talk to a trusted tax expert to help you determine which retirement plans are best for you and how much to contribute. Call for a consultation. We would be happy to walk through this with you to help you maximize your tax benefits and your retirement income.