These 3 Retirement Accounts Can Be Your Hero, Baby | Smart Change: Personal Finances
There is a concept in retirement planning called tax diversification. The idea is that by contributing to various tax-advantaged accounts, you will be able to better control your taxes today and in retirement.
There are several different retirement accounts you can use, and each has its own tax treatments and withdrawal rules. Using just three retirement savings accounts — a traditional 401(k), a Roth IRA, and a health savings account — can provide a very flexible set of assets in retirement.
1. Traditional 401(k) and/or IRA
Many people have access to a 401(k) at work. The big draw of the 401(k) is the employer match. This is money that your employer will add to your account just to save in the 401(k) plan. There is no better return on investment than that!
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Contributions to a traditional 401(k) are tax-deferred. This means you don’t pay tax on that money today, but you will pay tax on your withdrawals. You will also not pay taxes on dividends or capital gains.
The contribution limits on a 401(k) are enormous. Employees can carry forward up to $20,500 of their salary into 2022. The employer contribution is on top of that. Then, some plans allow employees to max out the 401(k) with non-Roth after-tax contributions, with a total contribution limit of $58,000. If you are 50 or older, you can contribute an additional $6,500.
I’ve grouped a traditional IRA here because most people will benefit from eventually transferring their 401(k) to an IRA. IRAs offer more investment choices than most 401(k) plans, and most providers charge no fees.
2. Roth IRA
A Roth account works the opposite of a traditional retirement account. Instead of deferring taxes until retirement, you pay taxes the year you contribute. In exchange, you won’t have to pay taxes on your retirement distributions.
The Roth IRA is especially useful as a supplement to a 401(k) if you exceed the income limits for contributing to a traditional IRA. This would represent $78,000 of adjusted income for an individual or $129,000 for a married couple.
It’s also useful if you’re able to make after-tax contributions to your 401(k) and make an in-service withdrawal to a Roth IRA. It’s called the Roth mega-backdoor.
The limit for direct contributions to a Roth IRA is $6,000 per year. There is an additional catch-up contribution limit of $1,000 for people age 50 and older.
3. Health savings account
Health savings accounts (HSAs) are designed to help people with high-deductible health insurance plans pay for medical care. HSA contributions are tax exempt in the year they are made. If you pay the dues directly through your payroll, you can also avoid FICA tax (although it will reduce your Social Security pay). When you use the funds to pay eligible medical expenses, withdrawals are also tax-free.
But there is no rule that you must withdraw funds at the time of a medical expense. You can keep your receipts for years, allowing your money to grow in the HSA, before you decide to withdraw. Then you can withdraw funds tax-free in retirement.
If you don’t have eligible medical expenses, you can start withdrawing funds at age 65 without penalty, but you’ll have to pay tax on the distribution.
put it all together
The beauty of having all of these accounts is that you can have more control over your taxes in retirement.
For example, if you build a giant nest egg in a 401(k), you can make systematic Roth IRA conversions at the start of retirement. The benefit is that by lowering your traditional 401(k) or IRA balance, you lower your required minimum distributions later in retirement. And when you start collecting Social Security, you’ll be able to withdraw more from your Roth account, which won’t affect the taxation of your benefits.
Ideally, you will end up having enough money in your Roth and HSA accounts in retirement to be able to exercise complete control over how much you will pay in taxes in retirement. And while you can’t pay $0 tax on your retirement accounts, you can significantly reduce your tax burden by taking advantage of different accounts.
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