When it comes to retirement savings, the fundamental process is the same: work, save, then retire and live off your savings. Sounds simple, right? But there are numerous considerations and I will detail a few below:
When Should I Start Saving for Retirement? The short answer is NOW! Even if you can only afford to contribute $25 a month, it’s a starting point. That’s because the sooner you begin to save, the more your money can grow. So $25 a month is $300 for the year, but the interest compounds each month you make a contribution. If you consider just that $25 contribution every month for 25 years, at 4% interest, you will have saved $12,853. Of course, it is likely that you will need more than that to survive your retirement years, but it’s a demonstration of how starting now can add up over time.
Should I Use Tax-deferred Type of Accounts? Tax deferred means you are not paying federal income tax now in lieu of paying the taxes in the future when you take withdrawals from your retirement savings account like a 401k, IRA, or annuity. Delaying taxes until withdrawal also means earning interest on the money you would otherwise pay taxes on.
Roth IRAs function in the opposite way. Contributions to Roth IRAs aren’t tax-deductible, but qualified withdrawals in retirement are tax-free. Essentially, it’s a matter of paying taxes now (Roth) or later (traditional).
At the end of 2017, former President Donald Trump signed a massive tax bill known as the Tax Cuts and Jobs Act (TCJA) that reduced individual tax rates over the course of the next 8 years enabling you to boost savings. (Hopefully you took advantage by saving!)
However, unless Congress votes to extend the TCJA, 2017 tax rates will go back into effect on January 1, 2026. Here is what could happen upon expiration:
- 12% tax rate goes back up to 15%
- 22% tax rate goes back up to 25%
- 24% tax rate goes back up to 28%
The key to making the most of the TCJA tax benefits before they end, or sunset, is to first understand your current tax bracket and associated marginal tax rate vs. the tax bracket you anticipate at your planned retirement age. With tax rates rising, your net income will likely decline. Of course, if the TC&JA gets extended, this point of consideration could be unnecessary.
But if they do not get extended AND you plan to retire in 2026, you could end up paying more in taxes. In this case, Social Security monthly payments will become taxable income when you retire, along with any withdrawals from tax deferred accounts being taxed at the increased rates. This equates to paying more in taxes and having less money in your pocket.
Should I Contribute to an Account with Money that’s Already Been Taxed? One thought is that if you pay the tax up front, then you are not subjected to the government’s mandate on when to take your distributions also known as RMDs. A bonus to this is that you can avoid potentially being bumped up into another tax bracket by the mandated distribution. So you can avoid the bump up by taking the distribution amount up to the amount of the next tax bracket without it costing you the increase cost difference of the next bracket percentage.
What are the Over-Arching Considerations to Making Retirement Contributions? Just like I always say with taxes, every tax return is unique to each filer’s personal situation. But in summary, two questions I would ask:
- Do you think taxes will be going up or down? Ahhh, the elusive crystal ball! If we only knew! If you knew taxes were going down by the time you retire, then maybe it makes sense to put your money in tax-deferred accounts. On the contrary, if you think tax rates will increase, then you might want to make after-tax contributions.
- Do you think your income will be going up or down? Again, if we could be certain of what the future holds, these decisions would be so much easier! But when you consider this question, you also need to consider potential windfalls, life events and other situations that may occur between now and your retirement years that could have an impact.
What you have read thus far may have opened up pandora’s box of questions. Although I do hope it may have inspired some to give this subject more consideration. Again, every taxpayer situation is unique based on their history, present situation and what the future holds. But if I can make one suggestion, that is to start saving today. And if possible, max out the contribution limit.
If you would like us to help you experience a Less Taxing Life and More Prosperous Solutions, contact us at 301-714-2071 or at www.SaundersTax.com to schedule your consult today.