We’ve all heard the saying, “Variety is the very spice of life.” This quote came from a line from a poem written in 1785 – heck, even back then people appreciated that diversity keeps life interesting. Whether it means trying new foods, new traditions, or perhaps vacationing in new locations, this phrase signifies that we often have options in front of us that can make our lives better.
But you know, this saying applies to our financial lives, too. After all, a sound retirement system is not comprised of just one investment. It takes a variety of financial tools that work together to create an integrated retirement system, one that offers you the best chance for financial success. A solid retirement program must be diversified to address risk, income, taxes, inflation, healthcare expenses, and more. And in my opinion, every, I mean every, sound retirement system should incorporate quantitative data to help mitigate downside protection so the upside can potentially take care of itself. It’s the master stroke of a qualified advisor to select the right tools to ensure these areas are all addressed within a client’s financial plan.
In fact, I had this very conversation with a guy in my office last week, I’ll call him Ted. From Barnstable, Ted is a widower in his late 50’s and wants to retire at age 65. He has no kids but has a large social network and is looking forward to playing golf and entertaining friends in retirement. He has been saving dutifully for years in his employer’s 401(k) plan, but he isn’t sure that it’s enough to sustain him in retirement. We explored a number of options, one in particular being the ability to contribute to more than one retirement plan, such as an IRA. Ted was surprised that this was an option for him, as are many folks I meet with. So, this week with our time together, I’d like to dig a bit into how a multi-plan approach might look.
So, you can save for retirement in a 401(k) plan and a traditional IRA at the same time. Both types of retirement accounts allow you to defer paying income tax on your savings and contributing to a 401(k) and traditional IRA could allow you to significantly reduce your current tax bill. Now, this won’t work for everyone, as high-income earners may not be able to claim a tax deduction on their IRA contributions in the same year they contribute to a 401(k). But for many, it is possible to defer paying income tax on as much as $25,500 ($33,000 at 50 or older) if you max out both accounts.
To qualify, employees who contribute to a 401(k) account can’t claim a tax deduction for a 2021 IRA contribution if their income exceeds $76,000 as an individual and $125,000 as a married couple filing jointly. So, you can defer paying income tax on up to $19,500 in contributions to a 401(k) plan this year. If you’re age 50 and older you can also make catch-up contributions of up to $6,500 for a total 401(k) contribution of $26,000. This is on top of the matching contributions that your employer may make to the plan on your behalf. We need to keep in mind that there are income limits, though.
IRAs on the other hand have a much smaller contribution limit of $6,000, plus an additional $1,000 catch-up contribution for workers ages 50 and older. Adding these contributions together, you can defer income tax on as much as $25,500 if you are 49 or younger and $33,000 at age 50 or older. And this can be a substantial amount of money – for example, someone in the 22% tax bracket who contributes $33,000 to a 401(k) and IRA will reduce his or her current tax bill by as much as $7,260. Income tax won’t be due on that money until it is withdrawn from the account, but remember it will be taxed as ordinary income.
And while contributions to a Traditional IRA may not be fully deductible or not deductible at all depending on income, this doesn’t mean you can’t contribute. It just means you don’t get the benefit of a tax deduction for the contribution for that year. You do, however, still get to enjoy tax deferred growth within the IRA, which can help your money compound more quickly than if the growth was taxed each year.
We can employ this same strategy using a Roth IRA instead of a traditional IRA, too, for potentially greater tax savings. As Cutter Family Finance followers know, a Roth IRA is funded with after-tax dollars. But, unlike traditional IRAs which has no income limit when it comes to eligibility to make contributions, individuals with high income limits are not eligible to contribute to a Roth IRA. Those who earn less than $140,000 as an individual and $208,000 as a married couple can make Roth IRA contributions in 2021. The contribution amount is phased out for those earning more than $125,000 as an individual and $198,000 as a married couple. The Roth IRA income limits apply regardless of whether you have a 401(k) at work, but as I have taught in previous columns, there are some ways around them, such as using a backdoor Roth or mega backdoor Roth strategy.
Contributing to a Roth IRA won’t get you a tax break in the year you make the contribution, but you will be able to take tax-free qualified withdrawals in retirement. Saving in a traditional 401(k) and a Roth IRA adds a level of tax diversification to your portfolio. When it’s time to start taking income in retirement, you can decide how much to withdraw from a taxable account and tax-free account each year, which can help you manage your tax bill.
These are just a few examples of how we can create a more tax-effective retirement system by diversifying our approach. Yup, it’s is all about creating options, folks.
So as always – be vigilant and stay alert, because you deserve more!
Have a great week.
Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. Insurance offered through its affiliate, CutterInsure, Inc. We do not offer tax or legal advice. Jeff can be reached at email@example.com.