This article on savings during retirement is original content written by Manchester, CT Financial Advisor Thomas Scanlon, CFP®, CPA
The Roth IRA and an IRA both offer different tax advantaged ways to save for retirement. If you are serious about your retirement plan take these 5 Easy Steps to Retirement.
In 2021, investors are allowed to fund a Roth IRA up to $6,000 per year. Additionally investors age 50 and older are allowed to fund an additional $1,000 in a so-called catch up contribution for a total contribution of $7,000. The Roth IRA can be funded at any time prior to April 15th of the year following the tax year. For example, a 2021 Roth IRA contribution can be funded anytime during 2021 and up to April 15th, 2022. To be eligible to contribute to a Roth IRA you will need two things. The first is earned income. Earned income comes from your wages if you are an employee. Additionally if you are self-employed this is considered earned income. You will need to have earned income at least up to the amount you are contributing to the Roth IRA. For married couples filing a joint return only one spouse needs to have earned income if they both want to contribute to a Roth IRA. A contribution is allowed for the nonworking spouse assuming the earnings will cover both of their contributions.
The only other requirement is that your income not be too high. In 2022, for married couples filing a joint return they are eligible to fund the Roth IRA if their modified adjusted gross income is under $204,000. When their modified adjusted gross income is over $214,000 they are not eligible to fund a Roth IRA. Taxpayers with income between these two amounts are entitled to a partial contribution.
With the Roth IRA there is no income tax deduction allowed. Therefore, when funding a Roth IRA you are doing this with after tax dollars. That’s OK. No worries. The benefit is if the account is open for at least five years and distributions begin after age 59 ½ then all of the distributions are tax-free. Distributions of earnings prior to age 59 ½ are generally subject to a premature distribution penalty of 10%. This is a huge difference with the IRA (as mentioned below). With an IRA you are entitled to a tax deduction and the account grows tax deferred. It is taxable however when distributions are made. Having tax free income in retirement is huge.
Another advantage to the Roth IRA is that it is not subject to the Required Minimum Distribution (“RMD”) rules like an IRA during the owners or surviving spouses’ lifetime. This allows the account to potentially grow tax free. Non-spousal beneficiaries like children and grandchildren are subject to the RMD rules if they inherit a Roth IRA. If the account was open for at least five years by the parents, the distributions to the children or grandchildren would also be tax free. You can see with potentially decades of tax free growth what a wonderful wealth transfer tool the Roth IRA is.
Unlike like an IRA, investors who have earned income can continue to contribute to a Roth IRA even after age 70. This allows folks that are still working to contribute to the Roth IRA.
Finally, you can always get back your Roth IRA contributions at any time income tax free. As you are not entitled to a tax deduction with a Roth IRA, you can get back your contributions at any time without income tax or penalty. While taking funds out of your Roth IRA before retirement it is not ideal for your financial plan, you can access your Roth IRA contributions at any time. Face it, things come up. Sometimes things you didn’t plan on. Investors should have an adequate cash reserve fund for these emergencies. Many commentators would suggest investors have at least six months of living expenses in a cash reserve fund. While I agree with the theory of this, the reality can be much more challenging. The bottom line is, you need a cash reserve fund. If you only have one month’s living expenses in reserve, so be it. Do what you can to move this up to two months living expenses. If you get have an emergency that exceeds your cash reserve fund, it’s nice to know you could access your Roth IRA. Again, not ideal but it is available.
If you have a Roth IRA it’s important to know The Difference Between a Roth Contribution and a Roth Conversion.
In 2019 IRA investors are also allowed to contribute up to $6,000 annually into an IRA. Investors age 50 and older can also make the so-called catch up contribution of $1,000 for a total of $7,000. Keep in mind, you can fund up to $6,000 (or $7,000) per year to a Roth IRA or an IRA or some combination of the two. That is the maximum that can be contributed assuming you meet the eligibility criteria.
To be eligible for an IRA you need to have earned income of at least the amount you are contributing. Unlike the Roth IRA, with an IRA you can’t make contributions after you turn age 70.
The biggest difference with an IRA and a Roth IRA is that the IRA is (generally) income tax deductible. Higher income taxpayers are not allowed to make tax deductible IRA’s. For a married couple filing a joint tax return if at least one of them is an active participant in a qualified retirement plan they can fund a tax deductible IRA if their modified adjusted gross income is income is $103,000 or less. When their income exceeds $123,000 they can’t fund a tax deductible IRA. For income between these amounts a partial contribution is allowed. An active participant in a qualified retirement plan is an employee that is participating in a 401(k) plan, profit sharing plan or a pension plan.
This account grows tax deferred. When distributions are made they are taxed as ordinary income. Higher income taxpayers are not allowed to deduct their IRA contributions. They are still entitled to fund their IRA; they just don’t get a tax deduction for them. These are known as nondeductible IRA’s. If you are contributing to a nondeductible IRA make sure you are tracking your nondeductible IRA’s that you fund. As you are not taking a tax deduction, when the principal comes out it won’t be taxed. This is tracked on IRS Form 8606, Nondeductible IRA’s.
Like the Roth IRA, IRA’s are subject to the premature distribution penalty of 10% if distributions are made prior to age 59 ½ with limited exceptions. Unlike the Roth IRA, distributions of principal (contributions) are not tax free. As was mentioned, there is no income tax deduction with the Roth IRA. Therefore you can access your contributions at any time without income tax or penalty. This is not the case with the IRA. As the IRA is tax deductible, any distributions from the IRA would be taxable income.
IRA’s are subject to the RMD mentioned above. Investors must begin to take out their RMD by April 1st following the year they turn 70 ½. The IRS has a table that instructs investors how much they need to withdrawal every year. Essentially the table has the funds being withdrawn over your life expectancy. Please make sure you take your RMD annually. Failure to your RMD will result in a penalty of 50% of the amount that should have been withdrawn. That’s not a misprint. The penalty is 50%! Savvy folks that are subject to the RMD will look at the 7 Reasons Why All Investors Over Age 70 ½ Should Consider a Qualified Charitable Distribution.
What’s an Investor to Do?
Well, if you are like most folks, there is only so much money to go around. For most employees the first place to start is with their employer’s 401(k) plan. The 401(k) plan is the most common plan offered by employers and will likely be one of your key assets in retirement. In 2022 employees can contribute up to $19,000 per year pre-tax into their 401(k) plan. There is also a catch-up contribution for investors age 50 and over. For the 401(k) plan the catch-up contribution is $6,500 making the total $25,500.
If your employer offers a 401(k) plan take a hard look at it. Many employers will offer a company match in their plan. If this is the case with your employer sign up and fund at least the amount needed to get the maximum match from the employer. Don’t leave this employee fringe benefit on the table. You’re going to need everything you can get to get to the retirement finish line. If they offer a 401(k) plan but don’t offer a company match, still take a hard look at the plan. If the menu of options is decent and the fees are reasonable, consider putting some money into your 401(k) plan. One of the obvious advantages to the 401(k) plan is that the employee contributions are payroll deducted. This can’t be overlooked. Having funds taken out of your check and invested for your retirement is huge. Remember, you can’t spend money you don’t have.
Also see if your employer offers a Roth 401(k) plan. This is similar to the 401(k) plan. It’s just that the taxation of a Roth 401(k) plan is similar to a Roth IRA. With a Roth 401(k) plan contributions are made to the account after tax. These funds grow and upon distribution is income tax free. If the employer offers a company match to the Roth 401(k) plan, this is done in the same manner as a traditional 401(k) plan. When funds are disbursed from the employer match on a Roth 401(k) plan, these are taxable income. In other words the employer match is not tax free upon distribution it is taxable. The contribution limits are the same as the 401(k) plan. Again, you can put up to $19,000 (or $25,500) into a 401(k) plan or a Roth 401(k) plan or some combination of the two plans.
If your employer doesn’t offer a retirement plan take a careful look at the Roth IRA. This may become the cornerstone of your retirement. Younger workers just starting out should fund the Roth IRA. As they are just getting started in their career, their income is likely lower. This means they are in a modest tax bracket. In a modest tax bracket tax deductions aren’t worth as much.
Whichever plan you use it’s important to have a beneficiary designation on the account. Typically, if you are married your spouse is the primary beneficiary. Then your children or perhaps grandchildren are the contingent beneficiary. You may want to name your favorite charities as your beneficiary. Caution needs to be exercised here when naming a charity. Seek legal and tax advice if you are considering this. Also, review your beneficiary designations at least every three years. Why? Everything changes!
While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.