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Wading through the options of saving for retirement

I am a big fan of financial security and I encourage my clients to set a habit of saving for retirement. It is never too late to start, but the earlier you start the more time you will have to grow your investments. Retirement experts and financial planners offer various rules of thumb about how much you need to save for retirement, but it cannot be argued that any habit of saving money will put you in a better place than if you procrastinate.

Sometimes the biggest stumbling block is deciding which type of retirement account is the best vehicle for growing your assets. Let’s consider the options:

Employer 401K plans (also 403(b) plans)

The workhorse of the American retirement system is the 401(k) plan through an employer. If your employer offers a 401(k) plan, this should be your first choice for savings. Setting a habit of saving is easier when the funds are directly deducted from your paycheck (less effort on your part) and often your employer will match some of your contribution. 401(k) plans also allow you to put a large chunk of money into retirement savings.

You get funds into your 401(k) plan through

  • elective deferrals of your salary ($20,500 for 2022 plus a catch up contribution of $6,500 if you are over 50)

  • employer matching contributions - often the employer safe harbor match is 4% of your salary

  • employer nonelective contributions - additional profit sharing allocations from the employer

Traditional IRA contributions

If you missed making a contribution in 2021, you may be able to contribute to a regular or ROTH IRA through April 15, 2022. For 2021 returns, you may contribute to a regular or ROTH IRA up to $6,000, plus an extra $1,000 if over 50. In my opinion, regular IRA contributions are good but not the best option. You can put much higher amounts into an employer retirement account. If your employer doesn’t offer a retirement plan option, then you should make the maximum contribution to your IRA or ROTH IRA each year. Regular IRA contributions are tax deductible. ROTH IRA contributions are not tax deductible (read the next section for more information on ROTH IRAs).

Note that you may not be able to make a regular IRA contribution if you could have participated in your employer plan, but chose not to. If you or your spouse is covered by an employer-sponsored retirement plan and your income exceeds certain levels, you may not be able to deduct your entire IRA contribution.

ROTH IRA and Backdoor ROTH IRA contributions

Roth IRA accounts are highly attractive to save for retirement because even though you don’t get a current tax deduction for your contributions, you can grow your investment tax free and also take tax free withdrawals in retirement. As a result, you don’t ever pay tax on the growth. This is a huge advantage for this type of savings.

The problem is that the IRS has set income limits on your ROTH Contributions. In 2022, if you are filing married filing jointly and your modified adjusted gross income is over $208,000 ($140,000 MAGI for a single person) you will not be allowed to make a ROTH IRA contribution.

High income taxpayers may get around this rule by implementing a Backdoor ROTH IRA contribution. A taxpayer can either make a non-deductible IRA contribution or a non-deductible 401K contribution (if their plan allows) and then the taxpayer converts the non-deductible contribution into a tax-free ROTH IRA. This works well if you can make a non-deductible IRA or 401K contribution and simultaneously make the ROTH conversion. If you have other funds in a regular IRA account you will pay tax on the conversion depending on how much “growth'' is in your account at the time of the conversion. If you don’t have any funds in an IRA and you do the contribution pretty close together (on the same day) the change in value will be minimal and your $6,000 IRA contribution turns into a ROTH contribution without an immediate tax consequence. This allows even high income earners to enjoy the tax free savings in a ROTH IRA account.

If you have questions about how to optimize your retirement savings or take advantage of the options available to you, please contact us.

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