Look into your crystal ball and decide whether you will be in a lower tax bracket when you retire. The future is cloudy. We used to assume that when your paycheck stops, your tax bracket drops. But that might not be the case in the future.
A long bull market has swelled the 401(k) accounts of today’s pre-retirees. And now that required minimum distributions (RMDs) are delayed until age 73, those larger distribution checks could land you in a higher tax bracket than you have considered.
It’s a high-class problem to have: too much retirement money pushing you into a higher tax bracket (and a higher Medicare Part B premium payment) when you retire. But if you’re among the smart and fortunate people who have contributed regularly to 401(k) plans, you have some tax planning to do now.
The big question is whether your current and future retirement savings should be done on a pre-tax or after-tax (Roth) basis.
What is a “Roth”?
All the gains in a Roth retirement account (named for William Roth, who proposed the legislation) come out free from federal income taxes (subject to certain rules for holding periods). And there are no RMDs from a Roth account during your lifetime. The tradeoff is that you don’t get a current tax deduction for your contribution to the plan. But if you don’t spend all your Roth money, it goes tax-free to your children, unlike traditional IRAs, where beneficiaries pay taxes on withdrawals.
Roth 401l(k) plans
About 7 in 10 large and mid-size companies now offer an after-tax Roth option as part of their 401(k) plan, although so far relatively few employees opt for these after-tax Roth contributions. Some companies make the Roth less attractive because their matching contributions apply only to traditional pre-tax 401(k) contributions. In that case, it’s wise to contribute enough to get the full match, before considering additional allowed contributions on a Roth after-tax basis.
Starting next year, high-earners will lose a valuable perk. For those age 50 and older, a “catch-up” contribution of up to $7,500 is allowed to a company 401(k) plan. But in 2024 those contributions can no longer be made to a traditional plan. Instead, the catch-up contributions can only be put into after-tax Roth 401(k) accounts if the worker earned more than $145,000 in the previous year. If your company doesn’t offer a Roth 401(k), you can’t make the catch-up contribution!
IRA basics
Everyone who has income from work, and who isn’t covered by a company or union retirement plan, should set up an individual retirement account. Many major mutual funds companies will let you open an IRA with as little as $1,000 if you sign up for an automatic monthly contribution from your checking account. Just choose a stock index fund such as the S&P 500 fund to make your money grow over the years.
IRA contributions can be made only if you have earned income from work. In 2023, the maximum annual IRA contribution amount limit is $6,500, or $7,500 if you are age 50 and older. This can be done in a combination of traditional and Roth IRA accounts, as long as you stay below the combined limit.
Working Lunch
Roth IRAs have income limits. For 2023, your modified adjusted income must be below $138,000 (single filers) or $218,000 (married filing jointly). At incomes above that, contribution limits phase out. There is no maximum income level for a traditional IRA contribution.
Importantly, a non-working spouse can contribute separately to a traditional or Roth IRA with the same contribution limits, as long as they file a joint tax return and the working spouse has earned enough month to cover both contributions. (There are some limitations if the working spouse also contributes to a company retirement plan.)
A special note: If your child has earned income from work or a summer job, you can contribute to a Roth IRA up to the limits, even if your teen already spent the money! Make it a Roth IRA so the money can grow tax-free for years.
Roth vs. traditional: The big decision
You can change your mix of Roth vs. traditional IRA contributions every year. But it’s worth considering the benefits of long-term tax-free growth, especially if you don’t really need the tax deduction now. As long as the government keeps its promise of future tax-free withdrawals, having some Roth-type accounts will likely bring you out ahead. And that’s The Savage Truth.
(Terry Savage is a registered investment adviser and the author of four best-selling books, including “The Savage Truth on Money.” Terry responds to questions on her blog at TerrySavage.com.)
©2023 Terry Savage. Distributed by Tribune Content Agency, LLC.