Build and preserve your nest egg with tax-smart planning
Retirement planning is one area that was only minimally affected by the Tax Cuts and Jobs Act (TCJA). Nevertheless, you should revisit it in your tax planning
this year. Tax-advantaged retirement plans can help you build and preserve your nest egg — but only if you contribute as much as possible, carefully consider your traditional vs. Roth options, and are tax-smart when making withdrawals.
401(k)s and other employer plans
Contributing to a traditional employer-sponsored defined contribution plan is usually a good first step:
- Contributions are typically pretax, reducing your taxable income.
- Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
- Your employer may match some or all of your contributions.
Chart 5 shows the 2019 employee contribution limits. Because of tax-deferred compounding, increasing your contributions sooner rather than later can have a significant impact on the size of your nest egg at retirement. Employees age 50 or older can also make “catch-up” contributions, however. If you didn’t
contribute much when you were younger, this may allow you to partially make up for lost time.
If your employer offers a match, at minimum contribute the amount necessary to get the maximum match so you don’t miss out on that “free” money.
More tax-deferred options
In certain situations, other tax-deferred saving options may be available:
You’re a business owner or self-employed. You may be able to set up a plan that allows you to make much larger contributions than you could make to an employer-sponsored plan as an employee. You might not have to make 2019 contributions or even set up the plan, before year-end.
Your employer doesn’t offer a retirement plan. Consider a traditional IRA. You can likely deduct your contributions, though your deduction may be limited if your spouse participates in an employer-sponsored plan. You can make 2019 contributions until the April 2020 income-tax-return-filing deadline for individuals. Your annual contribution limit is reduced by any Roth IRA contributions you make for the year.
A potential downside of tax-deferred saving is that you’ll have to pay taxes when you make withdrawals at retirement. Roth plans, however, allow tax-free distributions; the tradeoff is that contributions to these plans don’t reduce your current-year taxable income:
Roth IRAs. An income-based phaseout may reduce or eliminate your ability to contribute. But estate planning advantages are an added benefit: Unlike other retirement plans, Roth IRAs don’t require you to take distributions during your lifetime, so you can let the entire balance grow tax-free over your lifetime for the
benefit of your heirs.
Roth conversions. If you have a traditional IRA, consider whether you might benefit from converting some or all of it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth and take advantage of a Roth IRA’s estate planning benefits. There’s no income-based limit on who can convert to a Roth IRA. But the converted amount is taxable in the year of the conversion.
Whether a conversion makes sense depends on factors such as:
- Your age,
- Whether the conversion would push you into a higher income tax bracket or trigger the 3.8% NIIT (see page 13),
- Whether you can afford to pay the tax on the conversion,
- Your tax bracket now and expected tax bracket in retirement, and
- Whether you’ll need the IRA funds in retirement.
Warning: Unlike before the TCJA went into effect, you can’t change your mind during the year and recharacterize a Roth conversion back to a traditional IRA.
“Back door” Roth IRAs. If the income-based phaseout prevents you from making Roth IRA contributions and you don’t have a traditional IRA, consider setting up a traditional account and making a nondeductible contribution to it. You can then immediately convert the contributed amount to a Roth account with minimal tax impact.
Roth 401(k), Roth 403(b), and Roth 457 plans. Employers may offer one of these in addition to the traditional, tax-deferred version. You may make some or all of your contributions to the Roth plan, but any employer match will be made to the traditional plan. No income-based phaseout applies, so even high-income taxpayers can contribute.
Early withdrawals from retirement plans should be a last resort. With a few exceptions, distributions before age 591/2 are subject to a 10% penalty on top of any income tax that ordinarily would be due on a withdrawal. Additionally, you’ll lose the potential tax-deferred future growth on the withdrawn amount.
If you must make an early withdrawal and you have a Roth account, consider withdrawing from that. You can withdraw up to your contribution amount without incurring taxes or penalties. Another option: If your employer-sponsored plan allows it, take a plan loan. You’ll have to pay it back with interest and make regular principal payments, but you won’t be subject to current taxes or penalties.
Early distribution rules also become important if you change jobs or retire. It’s usually best to request a direct rollover from your old plan to your new plan or IRA.
If you receive a lump sum payout, you’ll need to make an indirect rollover within 60 days to avoid tax and potential penalties. Warning: The check you receive may be a net of 20% federal income tax withholding. If you don’t roll over the gross amount (making up for the withheld amount with other funds), you’ll be subject to income tax — and potentially the 10% penalty — on the difference.
Could you be affected by retirement plan changes?
As of this writing, legislation has been proposed that would make a variety of tax law changes related to retirement plans. Here are some of the most significant changes that could affect you:
- Allowing penalty-free IRA withdrawals for the birth or adoption of a child,
- Repealing the maximum age of 70½ for making traditional IRA contributions,
- Increasing the age for beginning required minimum distributions (RMDs) from age 70½ to age 72, and
- Reducing the time period for RMDs for most beneficiaries inheriting IRAs other than surviving spouses.
For the latest information on this retirement plan legislation, contact your tax advisor.
Required minimum distributions
Historically, in the year in which a taxpayer reaches age 70½, he or she has had to begin to take annual RMDs from his or her IRAs (except Roth IRAs) and, generally, from any defined contribution plans. However, age may be increased. If you don’t comply with the RMD rules, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. An RMD deferral is allowed for the initial year, but you’ll have to take two RMDs the next year. And you can avoid the RMD rule for a non-IRA Roth plan by rolling the funds into a Roth IRA.
Waiting as long as possible to take distributions generally is advantageous because of tax-deferred compounding. But a distribution (or larger distribution) in a year your tax bracket is low may save tax. Be sure, however, to consider the lost future tax-deferred growth and, if applicable, whether the distribution could: 1) cause Social Security payments to become taxable, 2) increase income-based Medicare premiums and prescription drug charges, or 3) affect tax breaks with income-based limits.
If you’ve inherited a retirement plan, consult your tax advisor about the distribution rules that apply to you.
IRA donations to charity
Taxpayers age 701/2 or older are allowed to make direct contributions from their IRA to qualified charitable organizations up to $100,000 per tax year. A charitable deduction can’t be claimed for the contributions. But the amounts aren’t included in taxable income and can be used to satisfy an IRA owner’s
RMD. A direct contribution might be tax-smart if you won’t benefit from the charitable deduction.