We work, 40 hours or so each week, get 2-3 weeks vacation and the regular holidays off, all the while saving for our retirement. You are saving, right? At least 10% of your income if you are in your 20’s, more as you get older. It’s the only way to ensure you’ll enjoy that well deserved retirement.
On the road to retirement, there are some decisions you’ll have which can impact your taxes along the way. Your 401(k) and IRA accounts – should you choose the traditional pre-tax flavor or Roth? The Roth plan requires post-tax contributions, but allows tax free growth and distribution, in most cases. If the distribution is the result of a conversion or certain rollover in under 5 years after conversion and you are under 59-1/2, you may have to pay an additional 10% tax penalty. With pre-tax plans, you contribute to the plans with your funds without any taxes deducted so the distributions are taxable. So which one do you choose?
One approach to consider is to look at your marginal tax rate, and see how far into that bracket you are. For example, a single filer will be in the 15% bracket from $8,500 of taxable income right until $34,500. If you find that after deductions, exemptions, credits, etc, your taxable income is $38,000, it may not make sense to be in pre-tax retirement accounts for all your retirement savings. Since only the amount above $34,500 is taxed at 25%, by putting exactly $3,500 into a pretax 401(k) or IRA, you’ll reduce your taxable income so the last dollar is taxed at 15%, and none at 25%.
If your company offers a 401(k) with a company match, see if they also offer a Roth 401(k). If not, at least be sure to deposit enough to get the match, and then use a Roth IRA to top off your savings. If the Roth 401(k) is an option, you are usually able to change between this and the standard pre-tax 401(k) on a pay cycle adjustment. The process can be fine tuned a bit by using a traditional IRA and converting some of it to Roth, as needed. A bit of attention to your taxable income and your paystubs and you should be able to take advantage of the difference between these two tax rates.
On the retiring side, you can implement a similar strategy. As a single retiree, finding yourself with a mix of pre and post tax investment accounts, by choosing the pre-tax 401(k) and IRA to make withdrawals right up to the taxable income of $34,500, and Roth or other post tax money for anything above this, you can aim to live right on the edge of 15% through retirement.
With the 2011 standard deduction ($5800) and exemption ($3700) adding to $9500 right off the top, this is about all the median earner needs at retirement. If your withdrawals are a bit lower than this, consider the strategy of converting just enough IRA money to top off that 15% bracket.
It’s not as difficult as it might appear. By looking at last year’s return and adjusting slightly for this year’s numbers, you should have a good idea where 2011 will put your taxable income. Underestimate a bit, and convert just enough IRA money to Roth to hit your goal.
If in April, your return tells you went over, just recharacterize enough to get the taxable income number dead on. This strategy for the just-retired person will help bring that IRA balance down over time to avoid some potentially large RMDs (Required Minimum Distributions) after reaching 70-1/2. Please note: once you make contributions to a designated Roth account, you cannot later change to a pre-tax account.
Note – the rates I discussed are for the single filer. Take a peek at the page I linked above for the tax table for other filing status, the idea works the same with the numbers adjusted for status.