One of the most common long-term financial goals is saving for retirement. Whether it’s through your employer’s 401(k) plan, an Individual Retirement Account (IRA), or another qualified retirement plan, there are several ways you can save in a tax-efficient manner and obtain ultimate financial independence.
Tax-deferred vs. Tax-free accounts
A tax-deferred retirement account is a retirement vehicle where the contributions are made pre-tax, meaning you likely will receive an income tax deduction when the contribution is made. The contributions are then invested, and the capital appreciation and earnings are tax-deferred until you begin taking distributions. Distributions are generally taxed at ordinary income tax rates in the year they are received. Examples of tax-deferred retirement accounts are traditional IRAs and traditional 401(k) savings plans with your employer.
A tax-free retirement account utilizes contributions of after-tax money. After-tax means funds that have already been recognized as income on your income tax return. Earnings and capital appreciation within these retirement accounts are distributed tax-free at retirement. Examples of tax-free retirement accounts are Roth IRAs and Roth 401(k) plans.
So which is the best choice…the answer really depends on your personal circumstances. It may also benefit you to diversify the taxability of your retirement accounts. Things to consider include:
- Your age (and the age of your spouse, if applicable)
- Current income level
- Current tax bracket (which factors your spouse’s income)
- Expected retirement income level
- Does your employer provide a company match for a particular type of retirement account?
- Diversification between plans may provide tax savings opportunities at retirement as you may be able to time your withdrawals in a tax-efficient manner
Additional retirement savings vehicles
If you are self-employed or a business owner, there may be additional retirement options that can maximize your tax-deferment while increasing your overall retirement savings. These options could also benefit your current employees as well as make your business more attractive to future hires. Discuss these options with your CPA and/or CFP® to see if they can be implemented within your business. Some of these options include:
- Cash balance pension plan
- Money purchase pension plan
- Profit sharing plans
- Simplified Employee Pension IRA (SEP-IRA)
The savings potential with these plans could be significant and they are worth exploring for your business.
The power of saving and proper investing
If you’re reading this and you are in your 20s and 30s, you likely don’t feel the pressures to save for retirement compared to when you are in your 40s, 50s, and 60s. But every bit helps for the long-term. Presume this – if you put away just an additional $100 a month until you reach the age of 60, how much would you have saved? Presuming a modest 7% return after-taxes and inflation:
- $122,709 for someone 30 years old today
- $52,397 for a 40 year old
- $17,409 for a 50 year old
This really shows the power of investing for the long-term and how every $100 matters! Also – don’t forgot to pay attention to the investments that are inside your retirement accounts. Even small tweaks and reallocations along the way can make a big difference!
“Your Number” and keys to success
What’s your “retirement number?” What we are referring to is how much do you need to save to retire and comfortably live out your goals? The answer is different for everyone. The true key to retirement success is lifelong financial planning to keep you on track.
Points to consider when determining your “retirement number” include:
- What additional income streams (rental properties, social security, portfolio investments) will supplement your lifestyle in retirement – and how much will they be?
- What age do I want to retire?
- What will be my cost of living at retirement?
- How much do I want to travel? Give to charity? Leave for my family?
Required Minimum Distributions pushed to age 72
In December 2019, Congress passed a new law called the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act). This bill went into effect on January 1, 2020 and made some notable changes to retirement savings and distribution rules. One of the changes related to required minimum distributions (RMD). The law moved the RMD age from 70-½ to 72 for individuals that have yet to turn 70-½ by the end of 2019.
There may still be time for 2019…
If you didn’t contribute to your self-employed retirement account in 2019, there may still be time. Consult with your professional advisors to maximize your 2019 deduction.
Wolf Tax Advisory LLC is a tax, accounting, and business consulting practice based in Annapolis, MD. We believe in providing a five-star, full-service financial and tax advisory experience for our business and individual clients.
The statements listed in this newsletter are general in nature and not intended to be personal tax or financial advice. Please consult your professional tax and financial advisors for specific advice related to your circumstances.
