Last month I wrote a blurb about self-employed retirement accounts, focusing on the SEP IRA (fairly easy to implement) and Solo 401(k) (harder to implement, but with more potential tax savings). Today I want to share a few ideas for when & how to combine both employer-sponsored (whether you're the employer or not) and individual retirement accounts (like IRAs and Roth IRAs) to make the most of your retirement saving goals.
Here are some basic ground rules:
Most retirement accounts are what we call "traditional", meaning that your contributions are treated as pre-tax and are removed from your income on your tax return. So if you contribute to a traditional retirement account, that reduces current year income taxes. The tradeoff is that all distributions are taxed as ordinary income during retirement. This is true for traditional 401(k)s, SEP IRAs, and IRAs.
Roth accounts, on the other hand, offer no current year tax benefit. Instead, contributions to Roth accounts can grow tax-deferred while money is held in the account and are distributed tax-free in retirement. There are still penalties if you take out money early or if certain conditions have not been met, but otherwise you'll never pay taxes on that money again.
Please note: even though contributions to traditional retirement accounts reduce income taxes, they DO NOT reduce employment taxes like FICA or Self-Employment Tax. So even if you contribute the maximum to retirement accounts, you'll still have to pay employment taxes on all earned income.
Everyone, regardless of income, can contribute to a traditional IRA. However, the deductibility of those contributions depends on two factors: a) did you also participate in an employer-sponsored retirement plan and b) is your income above certain thresholds. (The details are a little dry, but you can read them here.) Keep in mind that employer contributions count, so you might "participate" even if you don't personally defer any compensation to the plan.
If you DO NOT participate in a workplace retirement plan, then traditional IRA contributions are always deductible – regardless of income. If you participate in a workplace plan and your income is below the IRS thresholds, then you can still deduct contributions. If you participate in the workplace plan but make too much money, you can still make non-deductible contributions. (Why would anyone do that? We'll look at that later in the month.)
Roth IRA rules are different. Whether or not you can contribute to a Roth IRA only depends on your income, regardless of any workplace plans. So if your income is below certain thresholds, you can completely max out both your workplace account and a Roth IRA. If your income is above certain thresholds, you can't contribute at all.
Ok, that's a lot of info. With me so far?
So why would you want to combine both employer and individual retirement saving? One obvious answer is to save more on taxes: if your income is low enough, contributions to a workplace account and a traditional IRA will both reduce your taxable income. Everyone like saving on taxes, right?
Another answer is to mix traditional & Roth accounts to have more options for how & when you get taxed on distributions during retirement. Here's the key: if you have a combination of both traditional and Roth accounts, you have more control over when you pay taxes (or not) based on how & when you pull money from each account.
Since Roth distributions are tax-free in retirement, the IRS doesn't care when (or if) you take that money out. But, since traditional retirement account distributions are taxed in retirement, the IRS wants to make sure they get their slice and require you to take distributions after a certain age. (These are called Required Minimum Distributions (RMDs), and you can read more here.)
Generally speaking, people are most able to deal with a tax burden right after they stop working and least able towards the end of life. Makes sense, right? If you save in both traditional & Roth accounts, you can choose to take money from traditional accounts first (when you can theoretically deal with the tax hit) and save Roth distributions until much later in life. By waiting an extra 10, 20, or even 30 years to take money from Roth accounts, those investments can continue to compound for a potentially huge (and tax-free) upside.
So how does that translate to your life?
First, if you're not saving at all for retirement, just get started in whatever account seems easiest. There's no need to worry about optimizing everything if you're starting from scratch.
Secondly, if you feel like you're a bit behind on your retirement savings, you can look at combining different types of account contributions to help you put away more money, reduce taxes in the short-term, and set yourself up for a better tax situation later in life. FYI – as long as your income is below the Roth threshold and combined contributions don't exceed the annual limit, you can split your IRA contributions between a traditional and a Roth account. So even if you don't have a workplace account, you can still take advantage of the ol' trad & Roth combo.
Holy smokes, that's so much information! If you have a question about how you could save more for retirement, send me an email. I'm always happy to have a conversation.
Or prefer to ask a question face-to-face (or Zoom-to-Zoom), but don't want a sales pitch? Sign up for weekly Office Hours. We can have a quick conversation with zero stress and no strings attached.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
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