How to minimize taxes when saving for retirement
Note: The information presented below is for educational purposes only. It is believed to be accurate and applicable to most individuals. However, it is not a complete representation of all investment options available to you, and there are some exceptions, though rare, that could contradict the information below. Please consult with a financial professional before acting on anything you read below.
Past performance does not guarantee future results, and all investing carries risk, including loss of principal.
“Carla wants to do more, but she’s afraid of making the wrong decision.”
Earlier this year, I spoke with a woman named Carla who is in her fifties and her peak earning years. She said her cash flow (i.e. what is left once the bills are paid) is good, and she wants to save, but she isn’t sure where to save this excess money.
She currently has her money saved at the local bank earning a little interest. She wants to do more but is afraid of making the wrong decision.
I often get asked “what should I do with my money?”. The truth is, I can think if a dozen “good” things to do with your money; the real question is “What do you value?”. Money is a tool that enables us to do many things, and it’s important that your money is aligned with your values.
Because the rules are complicated and the options are seemingly endless, I have broken my answer into 3 parts.
In part 1, I’ll discuss saving for retirement, which I define as “making work optional”.
In part 2, I’ll talk about specific savings goals, such as kid’s or grandkid’s education, charitable giving, and saving for healthcare expenses, using 529 accounts, Donor-Advised Funds (DAF), and Health Savings Accounts (HSA).
In part 3, I will talk about advanced planning strategies you can use to maximize your after-tax wealth during – and, importantly, after – your lifetime.
Part 1: Retirement
How much do I need?
Payroll tax, AKA FICA tax, is a 7.65% tax on employee wages. It is deducted from your paycheck, so many people forget about it. This is a large expense that can be reduced or eliminated during retirement.
Saving for retirement is nothing more than saving money now to make work optional in the future. To make work optional, the rule of thumb is you need to have income in retirement equal to 70% of your working-years income. For example, a married couple who made around $120,000 during their working years would need around $84,000 income to maintain their lifestyle in retirement. For this calculation, income includes Social Security benefits, pension benefits, part-time work, and withdrawals from retirement savings accounts.
It’s important to note that rules of thumb based off income can be inaccurate. What’s actually important is what you spend, and the couple who makes $120,000, but saves $30,000, will likely be able to live on much less than $84,000 income in retirement. For the most accurate results, you need to consider what you currently spend and what might change in retirement, such as bucket-list vacations or the cost of a retirement home.
Where do I save?
Three places you can save for retirement:
Employer-sponsored plans (401(k), 403(b), SIMPLE IRA, etc.)
Individual Retirement accounts (Traditional IRA or Roth IRA)
Non-qualified accounts (not tax-advantaged)
In the context of retirement savings, accounts can be classified as “tax-advantaged” (meaning there is some sort of tax-deferral or tax-free quality) or “non-qualified” (in which you will pay taxes on income as it occurs). Tax-advantaged accounts are then classified on two separate axes: Roth or Traditional and employer-sponsored or individual. For this discussion, the “employer-sponsored or individual” distinction is important, as each type has different contribution rules and limits.
Keep reading to learn the rules of each account type, and to see an example of someone who is taking advantage of all these accounts.
1. Employer-sponsored plans
Medium to large employers
Many employers offer retirement plans as a benefit to employees. For medium-to-large for-profit companies, the most common plan is a 401(k), named for the section of tax code in which the plan was created. A non-profit organization such as a school or hospital may offer a 403(b), which is similar to a 401(k).
Most retirement plans include some sort of employer match, in which your employer will “match” the contribution you make, up to a certain amount. Under a common matching structure, your employer will match all of the first 3% of employee contributions, and then match half of the next 2% of employee contributions, for a total of 4% match on a 5% employee contribution.
“The employer match is often called ‘free money’.”
Some 403(b) plans also have a special additional match for employees with 15+ years of service who have contributed less than $5,000 per year to the 403(b). Please contact your HR or plan administrator for more information.
The employer match is often called “free money”, and unless you are living paycheck to paycheck, it is generally a good idea to take full advantage of this benefit.
The 2024 annual contribution limit for a 401(k) is $30,500 if you are 50 or older ($23,000 if you are under 50).
Within a 401(k) or 403(b), you can choose from a limited menu of investment options selected by your employer. Each plan is a little different, but most plans offer a “target-date fund” which is intended to be an all-in-one fund. You can select a fund based on your anticipated retirement date, and over time, the target-date fund will generally become more conservative based on your age (i.e. as you approach retirement). These funds are usually a good place to start, but because they are based on nothing but your age, they may not be the best option for your specific situation.
One word of caution to 401(k) participants is to look for the expense ratio of the fund(s) you invest in. An expense ratio represents the amount of fees you pay to the investment manager each year and can silently erode the value of your account. In my opinion, an expense ratio of over 0.50% is probably too high and I would see what other investments are available within your 401(k) or elsewhere.
Small employers
Some small employers offer what’s called a SIMPLE IRA, which is like a 401(k) in that your employer sets up the plan and offers matching contributions but is like an IRA (discussed below) in that you, the employee, must manage the account.
The most common SIMPLE IRA matching structure is where the employer matches the first 3% of your employee contributions. Like the 401(k) match, this is referred to as “free money”.
If you are 50 or older, you can defer up to $19,500 ($16,000 if under 50) of your earned income to a SIMPLE IRA. This is rare, but if you are eligible to contribute to both a 401(k) and a SIMPLE IRA, it’s important to know that the contribution limits are combined, and your contributions may not exceed the 401(k) limit.
Because a SIMPLE IRA is self-directed, you have access to a much wider range of investment options. If you have a SIMPLE IRA and are unsure how to view or select investments, your employer can provide you with information.
2. Individual Retirement Accounts (IRA)
If you have earned income, you can make contributions to an Individual Retirement Account (IRA). A Traditional IRA gives you a tax deduction today (subject to limits, see below) and tax-free growth, but withdrawals are taxed. A Roth IRA does not give you a tax deduction today, but has tax-free growth and withdrawals. We discussed the Roth vs. Traditional decision in another post.
The amount of your contribution is limited to the lesser of your earned income or the limits explained in the paragraphs below. Within an IRA, you have broad investment options, including stocks, bonds, mutual funds, ETFs, and money-market funds.
The IRS limits the contribution you can make to an IRA. The IRS also imposes limits based on your income and participation in a workplace retirement plan.
In 2024, the annual IRA contribution limit is $8,000 if you are 50 or older ($7,000 if you are younger). This amount applies in the aggregate to Roth and Traditional IRAs, meaning your total contribution across all IRAs is limited to $8,000 (if you are over 50).
Roth IRA
Roth IRAs are further limited depending on your Modified Adjusted Gross Income (MAGI). MAGI is calculated as AGI (found on Line 11 of your 1040) minus any amount attributable to a Roth conversion, plus add-backs of certain deductions, the most common of which is the student loan interest deduction. If you are married filing jointly and your MAGI is below $230,000, you can contribute the full amount to a Roth IRA. If you are single, the limit is $146,000.
MAGI for Roth IRA = AGI - Income from Roth conversion + add-backs (student loan interest deduction, etc.)
If you are above those thresholds, you may be able to do what’s called a backdoor Roth, in which you contribute funds to a traditional IRA and immediately convert the contribution to a Roth IRA. The backdoor Roth IRA can create taxable income if you already have pre-tax money in a traditional IRA. Do not attempt a backdoor Roth IRA without first speaking to a financial professional.
Traditional IRA
There is no income limit on contributions to an IRA, but if you are covered by an employer-sponsored retirement plan, you may not be able to deduct the IRA contribution (thus removing much of the benefit of a Traditional IRA). If you are single, the MAGI limit is $77,000. If you are married filing jointly and covered by an employer-sponsored retirement plan, the MAGI limit is $123,000. If you are married filing jointly and you are not, but your spouse is, covered by an employer-sponsored retirement plan, the MAGI limit is $230,000.
MAGI for Deductible IRA = AGI + add-backs (student loan interest deduction, etc.)
If you are above any of these MAGI thresholds, you may be able to utilize a backdoor Roth IRA. See above.
MAGI thresholds include a “phaseout”, which means the contribution limit slowly goes to zero as your MAGI increases. For simplicity’s sake, I only included the lower threshold in the text above, but the table below displays the phaseout range:
3. Non-qualified accounts
If you have maxed your contributions to your tax-advantaged accounts, or if you need to access your money before age 59 ½ (the age at which retirement plans are accessible without penalty), you may want to consider a non-qualified account.
A non-qualified account is defined by what it is not: there is no special tax treatment in this type of account. A non-qualified account can be a bank account that holds cash, a money market account that holds short-term interest-bearing debt, or a brokerage account in which you can buy stocks and bonds.
Stocks can be a great long-term investment, but be careful investing money you need within five years.
My opinion is the best way to generate long-term return on your investment is to invest in high quality publicly traded stocks. However, there is no guarantee that stocks will be profitable in the future, and there is a large risk in buying stocks with money you plan to use in the near future.
When you decide to save in a non-qualified account, the biggest question is “When do I need the money?”. The downside to the growth potential of stocks is the possibility that over a short enough period, your stock investment could actually lose money. If you need the money within five years, it is probably a good idea to keep it in something safe such as a money-market account or a short-term bond.
No matter what you want to invest in, a good brokerage will have options available to you. Companies like Fidelity, Schwab, and Vanguard have thousands of investment options from stocks to short-term money market funds.
You will have to pay taxes on any income generated within this account, but the silver lining is you can withdraw money from the account without penalty, making it a great investment option for money you want to access before age 59 ½.
Summary of contribution limits:
*401(k) and SIMPLE IRA have an aggregate limit of $30,500 ($23,000 under 50.) Traditional and Roth IRA have an aggregate limit of $8,000 ($7,000 under 50).
Example
Kathy is 52 years old and earns $70,000 at her job. She and her husband file jointly, their MAGI is $122,000, and she wants to save $42,000 this year. She wants to contribute as much as possible into her tax-advantaged retirement accounts and the rest of her savings into a non-qualified brokerage account.
She defers $30,500 of her salary into her company’s traditional 401(k) plan. Her company matches up to 4% of her salary, which is $2,800. This match does not count toward her annual contribution limit. She chooses to invest her contributions into a target-date retirement fund.
She isn’t sure if a Roth or Traditional IRA is appropriate for her, so she contributes $4,000 into each type of account to reach the $8,000 limit. Because she is under the MAGI threshold, she can deduct the $4,000 Traditional IRA contribution from her income. She invests her IRA contributions into a model portfolio of stocks and bonds she read about online.
To reach her goal of $42,000 saved, she contributes $3,500 into a non-qualified brokerage account. Because she may need to buy a new car soon, she chooses to invest the money in a money-market fund.
The $34,500 Kathy saved or deferred into Traditional accounts is not included in her taxable income. The money will grow tax free, and she will pay taxes on the amount she withdraws, which she can do without penalty at age 59 ½.
The $4,000 Kathy saved in a Roth IRA will be included in her taxable income, but the money will grow tax-free and can be withdrawn without tax or penalty beginning at age 59 ½.
The $3,500 Kathy put into a money market fund is always available to her without penalty, but she must pay taxes on the income generated by the fund.
Next week, I’ll explain how to save for common goals people pursue once they’ve saved enough to make work optional.
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