The right investment advice is critical, especially for retirees. As part of that, tax planning is highly valuable to ensure you’re getting the most out of every dollar you’ve worked so hard to earn and save. A key component of tax planning is proper asset management—identifying which strategies to implement across your entire portfolio.
While asset allocation may drive returns, the correct strategy is essential to making those savings go further. That’s where tax-advantaged accounts come in. As a financial advisor in Pittsford, NY, here’s what you should know about tax-advantaged retirement accounts.
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What are Tax-Advantaged Retirement Accounts?
Tax-advantaged retirement accounts are savings/investing accounts that offer some sort of tax benefit, typically a deferral or exemption. They are accounts created by the IRS to incentivize retirement savings.
With a regular brokerage account, you fund it with after-tax dollars, receive no tax deductions for your contributions, and the IRS will tax you on any dividends or capital gains realized from a profitable investment.
Comparatively, tax-advantaged accounts will offer you some sort of tax benefit along the way, though you will incur a penalty for withdrawals made before age 59½. Because of their tax-efficient nature, the IRS has placed contribution limits on each account type. You can view the breakdown in the table below:
|Account Type||2021 Limit||2022 Limit|
|401(k) or 403(b) Plan||$19,500*||$20,500*|
|IRA (traditional or Roth)||$6,000*||$6,000*|
|Health Savings Account (HSA)||$3,600 self/ $7,200 family||
$3,650 self/ $7,300 family
*For those age 50 and older, the IRS allows “catch-up” contributions (elective, additional contributions) in the amounts of:
- 401(k) or 403(b) Plan: $6,500 for 2021 and 2022
- IRA: $1,000 for 2021 and 2022
There are two primary types of retirement accounts, tax-deferred and tax-exempt.
As the name suggests, taxes on income are “deferred” to a later date.
Contributions to tax-deferred accounts are tax-deductible in the year they are made. Up to a set limit, any funds you contribute will reduce the total income you report on your tax return in that year. This type of contribution is commonly referred to as “pre-tax.”
From there, all accrued earnings grow tax-free and will only be taxed upon withdrawal in retirement at your then-current ordinary-income rate. Since your income may be significantly lower in retirement than currently, you will enjoy the difference as tax savings.
For example, if your taxable income this year is $100,000 and you contribute $10,000 to your 401(k), you would pay tax on just $90,000. Then, in 20 years, when you’re retired and your income is $30,000, you decide to withdraw $8,000 from the account and bump your taxable income to $38,000.
Common tax-deferred accounts are 401(k) and 403(b) plans and traditional IRAs.
On the other hand, tax-exempt accounts provide future tax benefits, but there is no immediate tax advantage today. Tax-exempt accounts do not allow you to claim deductions, meaning your contributions are made with “after-tax” dollars.
The primary advantage of this structure is that your earnings grow tax-free (like tax-deferred accounts), and retirement withdrawals are not subject to taxes.
For example, if you open a Roth IRA and contribute the max contribution of $6,000 per year (for those under 50), you would accumulate $83,095 (at a 7% interest rate) after 10 years. After 30 years, you would amass over $500,000. If you chose to withdraw $6,000 in a specific year, that entire $6,000 would not be taxable.
Common tax-exempt accounts are Roth IRAs and Roth 401(k)s.
The Most Popular Retirement Accounts
Here are a few of the most popular retirement accounts and their basic features:
401(k) and 403(b) Plans
A 401(k) plan is an employer-sponsored, tax-deferred, defined contribution plan. Both the employee and employer can contribute to the account, each up to their own annual limit.
Many 401(k) plans come with a “matching” incentive, by which the employer matches any amount an employee contributes up to a certain amount (usually between 2-6% of gross pay).
As noted above, the annual limit an employee can contribute to their 401(k) is $19,500 in 2021 and $20,500 in 2022. If the employer also contributes, the total combined contribution amount is capped at $58,000 for 2021 and $61,000 for 2022, or 100% of employee compensation – whichever is lower.
Like the 401(k), employers also offer a 403(b) plan. The primary difference between the two is the type of employer sponsoring the plan. 401(k) plans are offered by for-profit companies, whereas 403(b) plans are only available to nonprofit organizations, government employers, and educational institutions.
The exact investments available within your 401(k) or 403(b) plan will depend on the plan’s custodian.
Traditional and Roth IRAs
Individual retirement accounts (IRAs) are self-directed and self-funded. Although conventional and Roth IRAs have overlapping features, such as their annual contribution limits, there are a few notable differences.
Traditional IRAs, like 401(k)s, are tax-deferred, meaning your current contributions are tax-deductible, and your withdrawals (known as distributions) will be taxed at your income rate when you make them.
If you withdraw money from a traditional IRA before age 59½, you will pay taxes plus a 10% early withdrawal penalty, though you may be able to avoid the penalty in some cases.
Additionally, RMDs (required minimum distributions) apply to this account type and are amounts that must be generally withdrawn annually beginning the year in which you reach age 72.
On the other hand, Roth IRAs force you to pay the tax bill upfront, but you won’t owe anything after that. Your earnings will compound tax-free, and your withdrawals within retirement will not incur a tax liability. They are not subject to RMDs.
However, unlike traditional IRAs, Roth IRAs have income limits. In 2021, singles must have a MAGI (modified adjusted gross income) of less than $140,000 ($144,000 in 2022) to be eligible for contribution. Married couples must have a MAGI of less than $208,000 in 2021 ($214,000 in 2022) to remain eligible for Roth contributions.
There is a loophole to this income limit, which allows taxpayers making more than the eligibility ceilings to make traditional IRA contributions, convert that account into a Roth, pay a one-time tax bill, and then reap the benefits of their new Roth account. This is known as a “backdoor Roth conversion.”
Health Savings Accounts (HSAs)
Another popular retirement savings vehicle is an HSA. For those with a qualifying HDHP, pre-tax contributions can be made by either the employee or employer; the funds can be invested or not and can be used tax-free to pay for qualifying medical expenses.
Since the contributions are made pre-tax, earnings grow tax-free, and withdrawals for medical expenses are not subject to tax, HSAs represent the only “triple tax-advantaged” account available. Contributions can be used tax-free for medical, dental, and vision care and some other medical expenses.
Additionally, if you don’t need the money for healthcare costs, retirees can use HSA funds on non-medical expenses penalty-free beginning at age 65. However, these withdrawals will be subject to your current income tax rate (like your other tax-deferred accounts).
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