Maximizing your retirement savings is one of the the most efficient ways to build wealth. We rarely have the opportunity to earn and save money on a tax-free basis, and this is one of them. This blog will take you through some of the basics of a 401(k) and IRA alternatives.
Retirement Basics: 401(k) and Traditional vs. Roth IRA
401(k)/403(b)
A 401(k) is an employer-sponsored retirement savings plan that offers significant tax benefits while helping you plan for the future. A 403(b) is the nonprofit equivalent of a 401(k). With a 401(k), an employee sets a percentage of their income to be automatically taken out of each paycheck and invested in their account.
Contributing the maximum allowable amount ($20,500 in 2022) to your 401(k) each year should be considered the Holy Grail of investing. An absolute necessity for basic financial planning. If you are 50 or older, you can contribute up to an additional $6,500 for a total of $27,000 on a tax-free basis. This money
The best way to contribute is to dollar cost average, which means to invest a fixed amount each month to your 401(k). It’s a disciplined approach, and given extreme difficulty in “timing” a market, it enables you to forget about the daily ups and downs and follow the best proven strategy for investing.
If you are just starting a new job part way through the year, and if you have a savings buffer to get you through, ask to front load your contributions so that you get the full benefit of the maximum contribution. I once started a job in November after being out of work for several months, and on my 401(k) selection options, I chose to allocate all of my first three paychecks to my 401(k) so that I could max out for the year. It was painful without that stream of income, but avoiding paying taxes on $17,000 (at that time) made it worthwhile.
Even if yo have a 401(k) through your employer, you can ALSO contribute up to $6,000 ($7,000 if you’re 50 or older), to a traditional IRA annually. But if your income exceeds the IRS limits (depends on whether single, married, filing jointly or separately, etc.), you may lose out on the ability to deduct the IRA contribution from your taxable income. Your gains each year ae not taxable, but you will be taxed when you choose to withdraw monies from your IRA (presumably though, your retirement tax rate will be significantly lower than during peak earning years.
Traditional IRA
- Maximum annual contribution amount of $6,000 ($7,000 if you’re age 50 or older)
- Contributions you make to a traditional IRA may be fully or partially deductible, depending on your filing status and income, and
- Generally, amounts in your traditional IRA (including earnings and gains) are not taxed until you take a distribution (withdrawal) from your IRA.
- Money grows tax-deferred, and withdrawals are taxed as current income after age 59.5 (presumably as you get older, you will make less, and your tax bracket will decline)
Roth IRA
- You contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½.
- In addition to the general contribution limit that applies to both Roth and traditional IRAs, Roth IRA contribution may be limited based on your filing status and income.
Potential Benefit to Converting from Traditional IRA to Roth IRA
- A Roth IRA rollover (or conversion) shifts money from a traditional IRA or 401(k) into a Roth IRA
- A Roth conversion is especially attractive if you expect your future tax rate to be higher than your current rate because you don’t pay tax on withdrawals from Roth IRAs
- As a high-earner, you can also get around Roth IRA income limits by doing a rollover, a process commonly referred to as a backdoor Roth IRA
- You’ll owe tax on any amount you convert and it could be substantial
- Money grows tax-free, and unlike a traditional IRA, tax-free withdrawals
Other Information
- There is no age limit on making regular contributions to traditional or Roth IRAs
- If you file a joint return, you may be able to contribute to an IRA even if you didn’t have taxable compensation as long as your spouse did. Each spouse can contribute up to the current limit; however, the total of your combined contributions can’t be more than the taxable compensation reported on your joint return
