If your company sponsors a 401(k) plan, your employer may offer a match. Make certain you are contributing at least enough in 2017 to get the full match, which is essentially free money. The same is true when you are setting up your 2018 contributions late this year.
Example one: Jill Myers earns $100,000 a year working for a company that offers a 50% match on 6% of pay. For Jill, 6% of pay is $6,000, so Jill must be sure that she has contributed at least $6,000 to her 401(k) in 2017 to get a $3,000 match, and that she will contribute at least that much in 2018. That is an assured 50 percent return on her money.
Many companies now offer both a traditional 401(k) and a Roth 401(k). With the traditional version, contributions reduce taxable income and the current tax bill, but future distributions will be taxable. Roth 401(k) contributions offer no current tax benefit, but distributions will all be tax-free after age 59½, if you have had the account for at least five years.
If both versions are available, which should you choose for 2018 contributions? Employees in relatively low tax brackets may prefer the Roth 401(k) because the current tax savings will be modest and the advantage of tax-free withdrawals in retirement may be significant.
Employees in higher brackets may opt for the traditional 401(k) for upfront tax reduction. That is especially true for those who expect to be in a lower tax bracket after retirement. On the other hand, even plan participants with high income might choose the Roth side if they wish to have a source of tax-free cash flow in retirement and they already have ample pre-tax funds in the traditional 401(k). Note that all matches to a Roth 401(k) contribution will go into the participant’s traditional 401(k) account.
In 2017, the maximum you can contribute to a 401(k) as a plan participant is $18,000, or $24,000 if you will be at least age 50 at year-end. Currently, 2018 limits have not been released but some estimates indicate they could be $18,500 and $25,000. When you are finalizing your 2017 contributions and setting the amounts of income you will place in the plan in 2018, should you choose the maximum amounts? That could be a savvy selection, but you should consider the alternatives.
Instead of maxing your 401(k), you may prefer to pay down any credit card balances. Credit card interest is not tax deductible, so paying off a card with a 15 percent interest rate is the equivalent of earning 15 percent, after tax, with no investment risk. It is possible you will earn that much or more with an unmatched 401(k) contribution, which offers tax deferral, but that is not a sure thing.
The choice between unmatched 401(k) contributions and paying down a home mortgage or student loans is a tougher call. Mortgage interest usually is tax deductible, and student loan interest might be, as well.
Example two: Jill Myers has a mortgage with a 4% interest rate. In her 25% tax bracket, Jill’s return on paying down the mortgage would be 3%, and after tax, 75% of 4%. Jill believes she could earn more than that in her 401(k), so she increases her 2017 contributions to her 401(k) at year-end and raises her contributions for 2018, rather than planning on sending extra amounts to reduce her mortgage balance.
If her company does not offer a Roth 401(k), Jill may have to make another choice. She could reduce the amount she will specify for unmatched 401(k) contributions and plan to contribute to a Roth Individual Retirement Account (IRA) instead. As is the case with a Roth 401(k), Roth IRAs are funded with after-tax dollars but may deliver untaxed cash flow in the future. Roth IRA contributions in 2017 can be up to $5,500 or $6,500 for those 50 or older.
Example three: Suppose Jill is age 40, and she has been putting $500 per month into her 401(k), for an anticipated total of $6,000 in 2017. As the year-end approaches, Jill believes she can contribute a total of $15,000 to retirement funds for 2017. Besides the $6,000 to get a full employer match in example one, Jill decides to put $5,500 into a Roth IRA and a total of $9,500 into her 401(k). Therefore, Jill has her employer increase her 2017 401(k) contribution by $3,500, and she also sets her 2018 contribution at $800 a month, or $9,600 a year. Jill has until April 17, 2018, to make her 2017 Roth IRA contribution.
IRA owners also have some year-end tax planning opportunities. Money in a traditional IRA compounds, tax deferred, but required minimum distributions (RMDs) take effect after age 70½.
Example four: Bert Palmer, age 75, has $1 million in his IRA. The IRS Uniform Lifetime Table puts his ‘distribution period’ at 22.9 years, so Bert divides $1 million by 22.9 to get his RMD for this year: $43,668. If Bert withdraws less, he will owe a 50 percent penalty on the shortfall. (If you are 70½ or older, you should withdraw at least the RMD amount).
Although Bert does not need the money for living expenses, he must take the distribution to avoid the penalty. That $43,668 is added to Bert’s other income, so the effective tax on that distribution can be steep.
Suppose that Bert dies with that $1 million IRA, which passes to his daughter, Carol. Carol must take RMDs each year, regardless of her age. If Carol is now a middle-aged, successful executive with a high income, those RMDs likely will be heavily taxed. Indeed, pre-tax money in a traditional IRA probably will be taxed when paid out, whether to the IRA owner or to a beneficiary.
Therefore, IRA owners may want to take distributions before age 70½. Careful planning can fine-tune the amount withdrawn at year-end 2017, keeping taxable income within a relatively low tax bracket. Withdrawn funds may be spent, given to loved ones, reinvested elsewhere, or moved to a Roth IRA for potential tax-free treatment in the future. Our office can review your specific situation to assess if it makes sense to reduce your traditional IRA before age 70½ and, thus, decrease the amount of RMDs for you and for your beneficiaries.