There’s no one right way to save for retirement. Weigh the pros and cons of each type of account. Then do the math to figure out which one will save you more tax in the long run.
There are many retirement savings accounts out there that offer tax savings and substantial long-term asset growth. But they’re not all equal. Choosing the wrong fit for you could end up complicating your retirement withdrawals and making your tax requirements more expensive in the long run.
The main two ways you can save tax on your investments are to either 1) pay less or 2) pay later. Many investors keep their high-income investments in taxable accounts, even though they’re also investing in tax-deferred accounts. By combining the high-income investments into the tax-deferred accounts, tax savings can be much higher.
But deferring tax can actually lead to problems, too, including:
- Income is taxed at standard rates, so you won’t see lower rates on your long-term capital gains.
- There isn’t the chance to profit from stepped-up basis when you die (when an asset’s worth can increase based on market value at your death).
- Penalty taxes apply to withdrawals before you’re 59 ½.
Keep in mind that retirement accounts are (spoiler alert!) meant for use in retirement, and not primarily for their tax-deferred benefits.
You can avoid the tax penalty for early withdrawal if certain conditions apply. These include:
- Health insurance payments if unemployed
- Medical expenses
- Higher education expenses
- Buying a home for the first time
- Separated from service and 55 years-old
- Qualified domestic relations order
- Permanent and total disability
Let’s take a look at the different types of retirement accounts and their various tax rules.
Traditional IRAs, 401(k)s, and the like
Common retirement savings accounts are individual retirement accounts (IRAs) which allow you to deduct contributions and account fees (as long as you don’t pay them with plan assets), and you can compound your earnings for retirement.
IRAs are tax-deferred accounts. You can contribute regular income, other savings, or sometimes even borrowed money. But deposits have to be cash – you can’t, for instance, transfer securities from other accounts unless they’re rollover contributions.
The types of investments you can hold in your IRA are many. These can include:
- Mutual funds
- Partnership interest
- Real estate
The downside is that any withdrawals before you reach age 59 ½ are subject to a tax penalty of 10%. After you hit that age, you can withdraw your funds as if they are your income, but you must start these withdrawals by age 70 ½. These withdrawals are fully taxable, unless your initial contributions were after-tax.
Other types of accounts are the spousal IRA and nondeductible IRAs. If you are or have a nonworking spouse, a spousal IRA is an option. Your IRA contribution subtracted from your combined income must be enough to cover the nonworking spouse’s contribution.
If you don’t qualify to deduct annual contributions, you can have a nondeductible IRA. This type of account allows you to withdraw funds, a portion of which will be tax-free. But keep track of contributions that have already been taxed – what you can do is add up all your nondeductible contributions, and divide that sum by the total of all your IRA account balances.
If you really need regular income before you hit the minimum age for withdrawal, you can annuitize your account, which provides you a string of equal payments. These payments continue until you’re age 59 ½, or for five years. To calculate these equal withdrawals, you can use the life expectancy method (divide your IRS life expectancy by current account balance), and the amortization method (divide your insurance life expectancy by current account balance).
You’ll also have to calculate your minimum required distributions each year after you hit age 70 ½. You do this by dividing the previous year’s account balance (as of December 31st) by the distribution period of your age.
This is very important because if you miss a required distribution, you will likely have to pay a tax of 50% on the amount you should have distributed.
Note that many people try to defer tax as long as possible by waiting to make withdrawals until they are absolutely required to. The problem with this strategy is that if, for example, you take your first and second required distribution in the same calendar year, your adjusted gross income (AGI) will increase and you may be pushed into a higher tax bracket.
The Roth IRA is a popular option because withdrawals are generally tax-free, but contributions aren’t deductible. You can participate in these accounts whether or not you are also in an employer plan, and your AGI must be less than $131,000, or $193,000 if you file jointly.
Qualified rollover contributions to your Roth IRA are allowed, regardless of your AGI. As with traditional IRAs, contributions must be made in cash. After you reach age 59 ½, you can start withdrawing funds and you won’t have to pay tax on that income.
Aside from the big tax-free withdrawal perk, other benefits include:
- There are no required minimum withdrawals on Roth IRAs like there are with regular IRAs.
- Distributions are not included in your provisional income, which determines Social Security tax.
- Your AGI won’t increase because of Roth IRA distributions when calculating PEP and Pease phaseouts.
- If you see a loss in your Roth IRA, you can liquidate your account and deduct the loss as a miscellaneous itemized deduction.
As far as conversions, keep in mind that if you convert your traditional IRA to a Roth IRA, your income may increase and thus your tax bracket. You could also see more tax on Social Security and Medicare benefits by converting, and it may affect college financial aid.
The 3.8% unearned income Medicare contribution on investment income may apply if you convert. And finally, when you recognize income from a Roth IRA conversion, you may be subject to alternative minimum tax.
It’s not always easy to choose which kind of retirement account is right for you. When you understand the benefits and downsides of more traditional IRAs and Roth IRAs but are still unsure about which to choose, our team can help. Contact Provident CPA and Business Advisors today. We can provide the advice you need to create a retirement savings plan that meets your tax needs.