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  • Writer's pictureKyle Norton

Retirement Account Basics

I previously talked about the tax implications of investments, but that information specifically excluded retirement accounts. This is because retirement accounts get preferential tax treatment. As a general rule, the activity that happens inside a retirement account is not taxed. This means that no matter what interest dividends, capital gains or losses take place inside one of these accounts, it will not have an impact on your taxes. One exception to this is the wash sale rule, as discussed in that previous post.

Let's dive into some details on some of the most common types of retirement accounts and tax considerations for each.

Types of Accounts

Individual Retirement Arrangements (IRAs)

There are two types of IRAs that an individual can set up for themselves, so I am going to focus on those two for this post: traditional IRA and Roth IRA.

Note: The other four types of IRAs (payroll deduction, SEP, SIMPLE, and SARSEP) are or were set up by employers on behalf of employees and are not very common.

Both the traditional and Roth IRA can be set up at most any bank or brokerage at any time. The contribution limit for these accounts in 2021 and 2022 is $6,000 per year ($7,000 if age 50 or older), and that is combined across all IRAs, not per account.

The main difference between a traditional IRA and a Roth IRA is when taxes are paid on income. For those who qualify, contributions to a traditional IRA are deductible in the year contributed, which means you do not pay tax on those dollars. Instead, tax is paid when money is taken out of that account during retirement. Roth IRAs work the opposite way. Contributions are made with post-tax dollars, so there is no deduction in the year they are contributed. However, no additional tax is due when distributions are made during retirement.

In addition, traditional IRAs reach a point where a required minimum distribution (RMD) will come into play. RMDs begin the year after you turn 72, and it ensures you begin drawing down on your retirement account, and the government can begin taxing it. RMDs do not apply to Roth IRAs during the lifetime of the original owner of the account.

One perk of an IRA that employer-sponsored plans do not have is that the deadline to contribute is not until tax day of the following year. This means you can wait until you are ready to file your taxes to decide how much to contribute, which allows you to maximize potential deductions.

Employer-Sponsored Defined Contribution Plans

Most companies will refer to their defined contribution plan as a 401(k). If you work for a non-profit or governmental organization, you may instead be offered a 403(b) and/or 457(b). All of these plans work similarly.

In a defined contribution plan, you as the employee set the rate at which you will contribute. This is usually set as a percentage of your paycheck. Many employers offer a matching contribution. If your employer offers a defined contribution plan, I encourage you to look at what you would need to contribute to get the maximum match your employer will give, and contribute at least that much. See example below in "How much can you afford?" You are always 100% vested in the contributions you make, so even if you do not stay long enough to vest in your employer's contributions, you can always take what you have contributed and roll it over to a new plan if you leave your current employer.

What is "vesting"?

In the context of retirement accounts, you can think of your percent vested as the percent you own. You are always 100% vested in your own contributions to a retirement account, which means you can take that money to a new plan when you leave the employer. On the other hand, the matching contribution your employer makes often takes time to vest, and this process can be different at each employer. Some employers phase in vesting gradually, maybe 25% each year for four years, and some do it all at once, where you may be 0% vested until you hit 4 years and you become 100% vested. Depending on that schedule, you may or may not be able to take any employer contributions with you if you leave your employer.

Defined contribution plans typically have a few options for how those contributions can be invested, though some employers will manage those investments on the employees' behalf.

Defined contribution plans can be treated as traditional or Roth, though not all employers offer a Roth option for their plans.

Contribution limits for these types of plans change periodically. In 2022, the contribution limit is $20,500, or $27,000 for individuals age 50 or older. In 2021, the contribution limit was $19,500, or $26,000 for individuals age 50 or older. If you participate in more than one plan, this limit applies to the total across all plans except 457(b).

Employer-Sponsored Defined Benefit Plans

Defined benefit plans, often called pensions, are not very common anymore as more and more employers have moved to defined contribution plans. A defined benefit plan provides a fixed, pre-established benefit for employees at retirement. This means that no matter what happens in the investment market, the plan is responsible for paying out a fixed rate of benefits to its retirees. This puts a great deal of risk on the pension plan and the employer, and it is more costly to maintain than a defined contribution plan. Defined benefit plans are different from all other plans here because the employee typically has no control over how funds are invested, and there is no control over the taxability of that income in retirement (i.e. the concept of "Roth" vs "traditional" does not exist in this context).

What is the best retirement setup?

There are a variety of factors, and the answer will be different for each person, but I will give some general guidelines on what to consider.

How much can you afford?

If you are in a situation where you are living paycheck-to-paycheck, it can be difficult to think about putting anything away for retirement, but there are a couple ways to get more for your money.

If you are eligible to contribute to an employer-sponsored plan that has a match, my recommendation is to contribute at least the minimum amount you can to get the maximum match out of your employer. Let's say your employer matches 50% of the first 4% you contribute to your 401(k) plan. In that case, if you are in a position where you can afford to give up 4% of each paycheck, your employer is going to kick in 2%, for a total of 6% of your paycheck being contributed to an account without you having to put up all 6%.

The second thing that can help is the Credit for Qualified Retirement Savings Contributions, or "Saver's Credit," for short. This credit is designed for lower income individuals who are at least 18, not claimed as a dependent, and not a student. An individual with adjusted gross income (AGI) under $34,000 in 2022 can get a portion of elective contributions to a retirement account back as a credit. The credit amount is 50%, 20%, or 10%, depending on the AGI, of up to $2,000 in contributions. The qualifying AGI levels change each year, so check here on the IRS website for the breakdown. Let's say you make $20,000 per year, and you contribute $1,200 to your IRA. You will get $600 back as a credit, so you effectively get $1,200 in your IRA by only putting in $600 of your own money.

These two methods can also stack on top of each other. So let's say you make $25,000 per year, and you are eligible for the employer match I mentioned above. You can contribute 4% of your earnings to your employer's 401(k), which would be $1,000. Your employer matches half of that for another $500. Then, when you file your taxes, you get 10% of your contribution back as a credit, which would be $100. This means you only contributed $900, but your account has $1,500 in it. This may not seem like a lot of money, but if you are able to do this year after year, it can grow quickly. Assuming a 5% annual return, this one-time $1,500 investment would grow to about $6,500 after 30 years. If you are able to contribute $1,500 each year for 30 years with 5% annual return, it would grow to over $106,000!

Do you think your tax rate will be higher now or during retirement?

This one is sort of a gamble, but when choosing between traditional retirement accounts and Roth, this is one of the key factors. There are a few different ways to look at this. Let's say you are early in your career, and you are currently in the 10% marginal tax bracket, but you expect to rise through the ranks and make significantly more money later in your career. This would give you more resources at retirement and likely put you in a higher tax bracket at that time. In this case, it may make more sense to choose a Roth account so that you pay tax on the contributions at 10%, which is likely the lowest rate you will ever experience in your life. Then those contributions will grow over the years and you can take distributions at no additional tax, even though your marginal tax rate at retirement will likely be significantly higher.

In another scenario, let's say you are nearing retirement, and you are making more money than you ever have before. You also know that when you retire in a few years, your income will be less. In this case, it likely makes sense to be contributing to a traditional retirement account. In this case, you are deferring that tax payment until retirement when you will likely have a lower marginal rate.

Now, what about the rest of the population who are uncertain about their career trajectory or are just risk-averse? For many people, it makes sense to hedge your bets and have some money in both pre- and post-tax accounts. That way, you will have some money that is taxable in retirement (and remember you will have to take RMDs on this), but you also have some "free" money in Roth accounts that you can take out at any time for no additional tax—or you can leave it in there for a rainy day.

What type of account do you qualify for?

When it comes to employer-sponsored plans, this question is pretty easy to answer. If you employer lets you contribute, you qualify. IRAs, though, have unique rules on who can contribute to what kind of account and when it is deductible. The rules here can be complicated, so I will go over them briefly in this post. If you are interested in more information, I encourage you to reach out to me to schedule time to discuss your particular situation. All of this information is for the 2022 tax year.

Traditional IRA

Everyone can contribute to a traditional IRA, but whether or not that contribution is deductible is another matter. If you (and your spouse, if married) are not covered by a retirement plan at work, your full contribution is deductible. However, if you or your spouse are covered by a workplace retirement plan, your IRA contribution may be limited at certain income levels.

If you are covered by a retirement plan at work, you can take a full deduction if your modified AGI is up to $68,000 ($109,000 married filing jointly) and no deduction if your modified AGI is $78,000 ($129,000 married filing jointly) or more, with a partial deduction allowed in between. Those who file married filing separately are not allowed a full deduction. The partial deduction begins immediately, and no deduction is allowed if modified AGI is $10,000 or more.

If you are not covered by a workplace plan but your spouse is, you can take a full deduction if your modified AGI is $204,000 or less, and no deduction if your modified AGI is $214,000 or more, assuming you file jointly. The rule for married filing separately is the same as above, with no deduction allowed with modified AGI at $10,000 or greater.

Roth IRA

Not everyone is allowed to contribute directly to a Roth IRA depending on income level. You can make a full contribution up to the limit if your modified AGI is up to $129,000 ($204,000 married filing jointly), and no contribution if your modified AGI is $144,000 ($214,000 married filing jointly) or more, with a reduced contribution allowed in between. Those who file married filing separately have unique rules for Roth IRA contributions. If you file separately and you did not live with your spouse at any time during the year, you follow the above rules. However, if you lived with your spouse at any time during the year, the reduced contribution begins immediately and no contribution at all is allowed with modified AGI at $10,000 or greater.

What if my AGI is too high to allow a deductible IRA contribution or any Roth IRA contribution?

In this case, it is possible to do what is called a "backdoor Roth." This is where you make a contribution to a traditional IRA and immediately convert that amount to a Roth IRA. The bank or brokerage that holds your IRA should be able to assist with this process. However, this is a more complicated tax strategy and should not be undertaken lightly, as it cannot necessarily be undone in a later year.


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