Understanding Your Retirement Plan: What Box Are You In?

It’s tax season and that means everyone and their assistant is telling you that you need to save more for retirement. While it may seem odd that planning for retirement goes hand in hand with paying taxes, there is some logic to it. Your retirement plan is a box where you can put money designated as retirement savings. That box can help reduce taxes.

First, please don’t take that literally. We aren’t suggesting to put money in a box and hide it under the bed or bury it in the backyard. Though we have heard stories about a man who came into the bank with a coffee can with an excess of $100,000 that he didn’t want his wife to know about. After she died, he dug it up to deposit it. At least it was the money he buried in the backyard, not her. (We understand she died of natural causes and had a very nice funeral.)

What’s with these boxes?

Understanding the Tax-Deferred Box with Retirement Plans

Picture a box. Money that goes in might be from an employer or you might voluntarily contribute. Generally, money goes into this box before you pay taxes.

Did you get that? Before you pay taxes.

That means Uncle Sam hasn’t gotten a pie of his pie yet. And he won’t get any for a while. While money sits in that box, Uncle Sam can’t touch it. You understood that right.

While your money is in the retirement box, it doesn’t matter if it grows from $1 to $1,000,000. Uncle Sam can’t touch it.

Until you take it out of the box. Since he didn’t get a piece of the pie before you put it in the box, he gets it when you take it out.

This box can be called a 401k, 403b, IRA, or annuity. There are a few other terms, but if you hear retirement account, chances are this box pertains to your money.

The Roth Alternative for Retirement Plan Boxes

The Taxpayer Relief Act of 1997 tried to think outside of the normal retirement plan box. What we mean by this is you could choose how money went into the box.

Remember that in the traditional model, Uncle Sam didn’t get anything upfront and got it when money came out of the box. Think about those numbers. Assuming a 25% tax rate, putting $1,000 into the box might save $250. There are ways it can save a bit more that we’ll get into in a moment. But let’s stick with the $250.

If that money grew in the box, not paying taxes until you took money out when you retired, you might be paying a lot more. Assume you took $10,000 out of the retirement box. That would be $2,500 at a 25% tax rate.

What the Roth IRA through the Taxpayer Relief Act of 1997 did was give you the option. Imagine the person who retires and cashes out his entire 401k. We’d never recommend this but people do it and take the money to retire to Arizona or Costa Rica.

The problem not only do you pay your tax rate, but that money is also counted as income. Your tax rate just went through the roof.

If you pay the taxes before the money goes into the box, the Roth IRA says that money in the box can grow without being taxed, and then no matter how much you take out there are no taxes.

Roth IRA Caveats

There are a couple caveats with the Roth IRA:

• Must wait until age 59 ½ until you withdraw tax-free and without penalty.
• Must keep the money in the Roth IRA for at least 5 years (so if you open it at age 57, you can’t withdraw it tax-free until age 62).
• No requirements to withdraw funds.

Traditional IRA Caveats

The traditional IRA box has requirements too:

• Must wait until age 59 ½ to withdraw without penalty.
• Required Minimum Distributions are mandatory starting the year you turn 70 ½.

Using Retirement Boxes to Plan for Retirement

Choosing the box requires talking to your psychic and tax advisor. The reason is you need to guess what your income will look like in the future. Some retirees have significant drops in income when they retire. Their income tax bracket goes down.

This means that the present-day tax liability is greater and maybe the traditional box is the better answer. Other people retire with a lot of investments and other retirement income not really seeing a lower tax rate.

Your tax advisor will help you run the numbers. But most will say if the current tax deduction from your income doesn’t drop the entire tax rate, then you should go with tax-free money later down the road if you can contribute to a Roth scenario.

Roth “boxes” have expanded. Now employers are offering Roth 401k programs that allow you to contribute more if you qualify.

What do you mean my income tax bracket can go down?

Consider someone with an annual income of $85,000. This is an individual filing taxes as a single person. That means his 2018 tax rate is 24% or $20,400. If he contributed the maximum $5,500 to his traditional IRA (Uncle Sam doesn’t get paid yet), then his income drops to $79,500. This drops him into the 22% tax rate, now paying $17,490 in taxes.

All his income is now affected by the lower tax rate, not just the amount contributed. The difference is saving $1,320 on the $5,500 or $2,910. That’s worth considering a fully deductible IRA contribution.

Contribution Limits for IRAs

Traditional and Roth IRAs have a maximum contribution limit of $5,500 annually unless you are 55 years of age or older. Then you can add $1,000 to the limit as a “catch up contribution” to help those closer to retirement save more.

If you like the idea of growing money tax-free at stock market rates, you’ll have to meet income guidelines. The IRS won’t let everyone do this and has phaseout thresholds.

The Roth IRA Phase-Out Requirements:

• Single or Head of Household: Full contributions allowed up to $120,000 and phased out until $135,000 in annual income.
• Married Filing Jointly: Full contributions allowed up to $189,000 and phased out until $199,000 in annual income.

If you don’t meet these requirements, Congress passed a loophole. You can open a non-deductible traditional IRA, meaning you didn’t take the deduction, and then convert it into a Roth. It’s a couple of extra forms, so really no big deal. But Congress likes people to jump through hoops.

One of the cool things with IRAs is you can use your tax refund to fund the IRA. That’s right you can take a traditional IRA deduction and wait for the refund to come to actually fund the IRA. This means you can fund the IRA for the previous year as long as you get that contribution into the account by the April tax filing deadline. You can’t file an extension for that.

Employer-Sponsored Plan Limits

The contribution limits for employer-sponsored plans are much higher than for an IRA contribution. The rule of thumb is $18,500 for 401(k) contributions unless your employer allows after-tax contributions. Then the aggregate cap is $55,000 which includes the first $18,500.

If you have a SIMPLE retirement plan, the contribution limit is $12,500 with a catch-up limit of $3,000. The SIMPLE is often used by self-employed individuals to get higher contribution limits to compete with those who have employer-sponsored programs like 401(k) plans.

Final Thoughts on Retirement Plan Boxes

Saving for retirement is not something you will regret. Whether you have a great pension or Social Security benefits, having additional income and access to capital to enjoy retirement is part of the reason we all work so hard.

Remember that the limits are the top end and you don’t need to max out to contribute. My most successful clients over the years were those who put a little aside every month, a bill they paid to themselves. It could be as little as $25 per month. This way you don’t need to find the money at the end of the year to fund it.