Are some retirement savings options better than others?

The short answer is yes, but the option that works best for you depends on a lot of factors. So, you got to weigh your options! Taxes are one of those key components that are often overlooked when considering which option is best suited for your plans to save for retirement.

Taxes, ha! The reality is the IRS will get their share, but once you learn to play by their rules you can keep more in your pockets. Where you choose to save your money could have profound implications on how much you have available to spend during your retirement years.

Most don’t realize how much control they have over their tax bill during their distribution years, and it all starts with how you look at taxes. In the eyes of the IRS, you have three options or tax buckets to choose from. Tax-deferred, tax-advantaged, and tax-free, as they are known come with their own sets of rules that if understood can be used to your advantage when designing your tax bill year over year. When it comes to retirement savings remember this, it’s not just what you have that matters, it’s what you get to keep that ultimately determines how deep your pockets really are.

The Most Commonly Used Retirement Savings Options

One of the most widely used retirement savings options is the employer-sponsored plan, also known as the 401(k). These plans are offered through your employer and they are for flexible, easy, and safe use which makes them so popular.

Two of the biggest perks that come with the 401(k) are that you can invest automatically straight from your paycheck, making saving for retirement convenient, but the biggest perk is the opportunity to receive what is essentially free money through an employer matching contribution.

Modern 401(k) plans come in two out of the three tax buckets: a traditional 401(k), where funds are contributed with pre-tax money, and Roth 401(k), where funds are contributed with after-tax money.

Here are a few of the rules that make 401(k) unique:

• There are no income requirements or limits, but you must have earned income through an employer that offers the plan.
• Contribution limits: $20,500 in 2022, workers age 50 and older can contribute an additional $6,500, for a total of $27,000.
• Generally, money can be withdrawn without penalties after age 59 ½. Roth 401(k)s have a slight nuance, the account must also be open for at least five years to avoid those penalties.
• In a traditional 401(k) you contribute pre-tax money, which comes with immediate tax deferral. Any money in the account comes with tax-deferred growth if markets allow, but is taxed at ordinary incomes rates at the time of distribution. The Roth 401(k) uses after-tax contributions, so there’s no initial tax break, but all money withdrawn (if requirements are met) will be tax-free.
• Early withdrawals are allowed but typically come with a 10 percent bonus penalty. Hardship withdrawals may allow for distributions that bypass this extra penalty and most plans allow for loans against your balance.

Plans available to us outside of the employer sponsored space offer different agreements with the IRS comparatively, the game changes slightly and the control in which you have to utilize those agreements goes up.

The most popular agreement made between savers and the IRS is known as an IRA.

These Individual Retirement Agreements allow you to create various tax-diversified savings to help provide financial security in retirement that is flexible to cope with changing tax codes. While there are many iterations of the IRA that all come with certain tax benefits, those specific differences ultimately depend on the type of agreement. The two most commonly used versions are the Traditional IRA and the Roth IRA.

The customization and autonomy over these plans are endless, how they are exactly utilized for the planning of tax mitigation is as much an art as it is a science. It is vital to have long-term perspectives in mind but then map out and monitor the more micro details as life unfolds. Said another way, think of the big picture first then make game-time decisions and audibles as needed.

Life isn’t lived on a spreadsheet, stay on top of current law changes and income requirements year over year and you’d be surprised how much more in control your tax bill really is. Utilizing IRAs are a fantastic way to shelter your savings from tax erosion, here is how the rules compare to their aforementioned employer-sponsored relatives:

Traditional IRA

• Must have earned income. There are no maximum income limits for contributing to IRAs. However, the tax deferability begins to phase out once your modified adjusted gross income reaches certain levels. The phase-outs vary depending on filing status and if you have access to an employer-sponsored plan, these rules can be complicated so it is vital to understand how they work and where you fall into them.
• Contribution limits: $6,000 per year in 2022, or $7,000 for those aged 50 and older.
• Funds can be withdrawn at age 59 ½ or after, but in most cases, any funds taken out before then will result in an additional 10% tax penalty. There are certain scenarios where the extra tax can be waived, so again, it is important to know these rules as well.

• The traditional IRA allows you to immediately deduct your annual contribution amount from your income taxes if you fall within the phases outs and income imitations. Then, any funds held inside these arrangements that grow do so on a tax-deferred basis until withdrawn and taxes paid at ordinary income rates.

Roth IRA

• Similar to its sibling, you must show earned income and there are both phaseouts and income limitations in order to contribute directly to a Roth IRA. There are certain mechanisms that can allow you to circumvent some of these income rules and still contribute to a Roth IRA, this is a strategy commonly known as the Back Door Roth. Again, it is important to know the rules of the game you are playing, they vary and their application will ultimately depend on your specific scenario.
• Contribution limits: $6,000 per year in 2022, or $7,000 for those aged 50 and older.
• You can expect that contributions can be withdrawn at any time, and once you turn 59 ½ any amounts (including earnings) may be withdrawn tax-free. There are some tricky 5-year rules to navigate, so be sure to know your timelines and the details of those provisions.
• Roth IRAs take after-tax contributions (so no immediate deferral) but then all investment growth and distributions can be tax-free. In theory, you could pull any sum of money out of a Roth IRA and it does not have any bearing on your annual tax bill.

Starting the IRA Journey

When it comes to opening up an IRA there is no shortage of options, just following the rules of the game are confusing enough but establishing these agreements, opening up accounts, and carry out the plans falls solely on your list of responsibilities and it can be difficult to know how to start. Here are a few helpful thoughts to get this type of planning underway.

Step 1: Choose the location of your IRA

The first step is to choose what type of institution you'll open your IRA through. There are a number of custodial options to choose from, including banks, brokerage firms, or robo-advisors. All of which can help provide you with guidance and easy access when establishing your plan.

These amenities and plans are not free, some are less expensive than others, and each institution or business will have its own options and customizations available. Whether you are hands-on or hand-free you get to choose how these accounts are managed in the day-to-day.

Before choosing where to house your IRA consider multiple options and don’t base your decisions solely on fees. IN this world you get what you pay for and everyone wants a different user experience, know the options and make an informed decision that best suits your knowledge, experience, and expectations for this aspect of your plan.

Step 2: Select your IRA account type

Looking back at the aforementioned differences between Traditional and Roth IRA’s, it’s easy to see how each account differs. What is much more challenging is knowing when and where to utilize the tool correctly.

Your plan may call for immediate deferrals as a way to help you mitigate your long-term tax liability, while other in other years paying the taxes today may be more beneficial. Be sure to educate yourself on the tax code, just by understanding how the game works you can save yourself a tremendous amount of money that would otherwise be lost to taxes.

There are certainly pitfalls inside the tax code, but there are also opportunities that exist as well. IRAs can play a vital role in helping you shelter your assets from taxes, consider which option is best for you, and apply those thoughts into action by giving yourself options.

Step 3: Open your IRA account

In today’s modern financial marketplace, opening an IRA is usually very simple, and often, done online through easy step-by-step processes. Although the experiences will be similar, this is where you can expect major differences in opinions from provider to provider. The exact process will vary.

Although each institution will carry out the respective steps how they see fit, there are many governing bodies that step in to make the process somewhat robust and standardized. Initially, these requirements may sound like too much, but understand they are in place for your safety and proper oversight of the financial services industry as a whole.

Step 4: Make contributions to your IRA

Once your IRA has been established, you can begin making contributions.

As long as you stay within the previously mentioned income and contribution guidelines you can get funds into your IRA in a number of different ways. Contributions can happen via check, or most commonly through electronic transactions linked through your bank account.

Something to point out is the difference between contributions and the various transfers that can be made from other accounts into your IRA. While contributions have guidelines and limitations based on income, a transfer does not. There are in reality a number of transfers that can be made into your IRA that does not count towards your annual limits or are subject to income guidelines.

Step 5: Start Investing your Funds

After you've funded your account, you can begin investing those dollars for specific goals within your plan.

Investing philosophy is not in the scope of this article but it is important to note that you can implement any number of different investment options inside your plan. An IRA is not an investment in and of itself, it is a vehicle that allows you to hold your investments with specific tax treatment. You can choose any level of risk vs. reward and create your own investment philosophy within your plan, the world is your oyster.

Similar to my comments surrounding long-term tax management, building an investment plan should focus on the bigger picture and long-term plans. Consider your specific spending goals and their timelines, creating buckets of money with dedicated jobs will make managing your investments through any market and life scenario much simpler.

We understand how difficult this big step in your life can be. If you are looking for guidance through this process, contact us for your next steps!

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Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.

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