Key Takeaways
You can still contribute to an IRA if you are also eligible to participate in a company 401(k).
Make sure teens and adult children in your life contribute as much as they can to a Roth. Consider matching them as an incentive to save.
Earn too much money to contribute to a Roth? See three simple ways for high earners to do a “backdoor” Roth.
SEP IRAs and Individual 401(k)s allow very small business owners to sock away more than they could with an IRA, Roth, or company 401(k) – and help their employees save too.
The deadline to file your 2021 taxes is fast approaching. But there are still some things you (and your adult children) can do to maximize tax savings and fortify your retirement planning before Tax Day. Here are four basic strategies that even some financially savvy people do not take full advantage of:
1. Traditional IRA. You can make tax-deductible contributions to an IRA of up to $6,000 a year ($7,000 if over age 50). Earnings grow tax-deferred until you withdraw the money in retirement. Many retirees find themselves in a lower tax bracket after their working years. So, the money you stashed away (i.e. “tax-deferred”) in your account throughout your working years has a good chance of being taxed at a lower rate when it comes time to draw it down in your golden years. An IRA is also a great way to supplement your employer-sponsored savings plan, such as a 401(k). It’s especially if you got a late start on your retirement planning or spent extended time out of the workforce.
Clients often ask if they can max out an IRA if they also have a 401K? Yes, you can also contribute to an IRA if you are eligible to participate in a company 401(k). However, if you want the tax deduction, the income limits are even lower than they are for a Roth. Phaseout starts at $66,000 filing single and $105,000 filing joint for 2021. In 2022 phaseout jumps to $68,000 and $109,000.
2. Roth IRA. Unlike a traditional IRA, Roth IRAs are funded with after-tax dollars rather than with pre-tax dollars. Roth IRAs won’t lower your taxable income like an IRA or 401(k) does, but your money will grow tax-free. Even better, you won’t have to pay tax on the money when it comes time to draw it down in retirement as you do with traditional IRAs. You already paid the tax when you made the contributions.
Like a traditional IRA, you can contribute up to $6,000 a year ($7,000 if over age 50) to a Roth IRA. The only catch is that you can’t contribute to a Roth IRA if you earned more than $140,000 (single) or $208,000 (married) in 2021. We recommend Roths to the adult children of many of our clients since they have a long time to accumulate savings. Roth IRAs are also useful for teens and college students (18+) in your life who had summer jobs or after-school jobs. They just can’t contribute directly more than 100% of what they earned in a given year. Parents can gift a contribution to their child’s Roth IRA up to 100% of their earned income capped at $6,000. A good incentive is telling them you will match their contribution to get them in the habit of saving.
3. Backdoor Roth. Even if you’re over the income limits for a Roth, you can still participate with this maneuver. First, make an after-tax contribution to a traditional IRA and then roll the money from the traditional IRA over to a Roth IRA without triggering a taxable event. We have a client over age 50 who makes over $1 million a year. His wife doesn’t work and didn’t have an IRA. However, after we set up a Roth for her, she was able to make $7,000 a year of non-deductible contributions into that IRA and then convert to a Roth IRA so the money grows tax-free.
3 ways to do a Backdoor Roth
Contribute money to an existing traditional IRA and then roll over the funds to a Roth IRA. Or you can roll over existing traditional IRA money into a Roth—as much as you want at one time, even if it’s more than the annual contribution limit.
Convert your entire traditional IRA to a Roth IRA.
If your company 401(k) plan allows conversions, you can roll your 401(k) account over to a Roth IRA.
This strategy best works if you have no existing money in an IRA outside of a 401(k) plan because you can make the conversion without any tax penalty. If you have pretax contribution money in an IRA and make the non-deductible contribution with the intent of converting to a Roth IRA, the conversion will be taxed proportionately on the percentage of pretax dollars in the account. For instance, if you have $50,000 in an IRA in pretax dollars, make a non-deductible $6,000 contribution, and plan to convert just the $6,000 to a Roth IRA, you will actually be paying income taxes on 89% of the conversion ($50,000/$56,000 = 89%). NOTE: the Biden Administration may try to eliminate this strategy again, so be sure to consult with your financial and tax advisors first.
4. SEP IRA and Individual 401(k). Both are great options if you’re a small business owner or otherwise self-employed. By essentially setting up your own “company” retirement plan, you can sock away far more than you’d be able to via an IRA, Roth, or 401(k). You can only set up the individual 401(k) if you have no employees and you have the ability to make both “employee” and “employer” contributions for yourself up to the total limit of $61,000 ($67,500 if you are over 50). SEP IRAs allow you to make an employer contribution of up to 25% of each employee’s compensation – including yours -- but the percentage has to be the same for every employee. The SEP is also subject to the limit of $61,000 ($67,500 if over age 50). Generally, SEP IRAs are best for self-employed people or small-business owners with few employees or with a spouse who’s an employee. Here's why: They are easy to set up, and provide a lot of flexibility in regards to making contributions. There is never a requirement to make a contribution into the plan which is helpful when things are tighter. If you have a few employees with lower salaries, you can provide the benefit to them while allocating a bigger contribution dollar wise to your own plan.
Conclusion As with IRAs and Roths, you have until April 18th to set up a SEP IRA or Individual 401k (employer contributions only). We’re happy to help. If you or someone close to you has concerns about your retirement savings and contribution options, please don’t hesitate to reach out. We’re very experienced in this area and happy to help.
DAN SATZ MS, CFP® is a Wealth Manager at Novi Wealth