We may not like paying taxes, but every March we start thinking about tax-related issues as the annual deadline looms. March is also the time of year when we spring clean – figuring out how to organize our houses and yards to get ready for the warm days ahead.
Given that your mind is already centered around these two topics, why not combine them and conduct a spring cleaning on your retirement portfolio to see if it’s as tax efficient as possible?
A Patchwork System
Retirement savings plans in the U.S. resemble a patchwork quilt your grandmother may have made for you. There are a confusing array of choices, tax implications and limitations that could bring joy to nobody except your tax accountant.
The system has evolved over many years as our country has moved away from the pension model. The burden of retirement planning is now squarely on your shoulders, if you’re among the majority of workers.
The system is uneven with regard to tax efficiency. Employees of a company that offers a 401(k) retirement plan can contribute up to $17,000 ($17,500 as of the 2013 tax year) on a tax-deferred basis. If you’re over 50, you can contribute an extra $5,500. But tax-advantaged contributions to traditional or Roth IRAs, the other major retirement savings vehicle, are limited to $5,000 ($5,500 as of the 2013 tax year, and $1,000 more if you’re over 50).
Max Your 401(k) Dollars If You Can
A 401(k) is the low-hanging fruit, assuming you have access to one. Maximize your contributions (i.e. up to that $17,000 limit with an additional $5,500 per year if you’re over 50, for the 2012 tax year). If your employer fully matches your contributions, you have an even stronger reason to save. This is clearly the most tax-advantageous plan for retirement.
IRA Considerations
If you don’t have a 401(k) or similar company retirement plan, consider opening an IRA. There’s lots of chatter about whether you should opt for a traditional or Roth IRA, but in many cases your age, income and marital status will help you make those decisions.
Two warnings: First, your ability to deduct your contributions to a traditional IRA may be limited, depending how much you earn. Second, there is an income limit for eligibility to make contributions to a Roth IRA. Here’s a handy table from E*trade that provides further details on these restrictions.
From a tax standpoint, the main difference between a traditional or Roth IRA deals with your marginal tax rate today versus your tax rate later (when you start receiving income from the investments). If you think your marginal rate will be higher later (e.g. if you are young now and have awhile before your peak earning years), then a Roth IRA may be more advantageous. If you think your future marginal rate will be lower, then a traditional IRA may be the right decision.
Investments Have Tax Consequences
If an IRA is your only option for a tax-advantaged retirement savings vehicle, you may need to invest in other, non-tax-advantaged vehicles to reach your retirement goals. For many people, saving $5,000 a year won’t be enough.
Even if your portfolio is subject to tax, you can make it more tax-efficient. If retirement is a long way off, consider a high level of equities. The capital gains won’t be taxed until you sell the securities. If you prefer mutual funds, consider the tax advantageousness of passive vehicles like index funds or exchange traded funds, which tend to have lower tax consequences than actively managed funds. Active funds are often buying and selling their underlying equities, and that creates tax consequences.
There’s no single best approach. Your tax strategy needs to depend on the specifics of your situation. Just remember that every dollar that works to your advantage now will benefit you greatly later on. If that’s not a great reason to “spring clean” your portfolio, what is?
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