Now is the time to get organized for tax day and make sure that you are taking advantage of all of the structures the IRS has set up to encourage long-term investing.
Max out your IRAs for 2019
You have up to April 15, 2020 to contribute up to $6k ($7k if you’re over 50) into one or multiple IRAs for the 2019 tax year. Assuming you aren’t covered by a retirement plan at work, contributing to a Traditional IRA is the one thing you can do after December 31 to reduce your tax bill for the old year.
Set IRAs on auto-pilot for 2020
If you have $6k on hand early in the year, it makes sense to put in your contribution right away and earn tax-free investment income all year. If you need to budget to fill your IRA, just login and set up regular deposits from your checking account ($6k / 12 months = $500/month).
Did you know that you don’t need to work to contribute to an IRA? That’s right, if your spouse has earned income in a given year, he or she may give you the money to max out your IRA. For a couple with one earner, this effectively doubles their lifetime tax savings. Investing $12k per year ($14k after 50) instead of $6k ($7k after 50) will also help ensure that you have socked away more than enough for a comfortable retirement. A spousal IRA isn’t a special kind of IRA. It’s simply a Traditional or Roth IRA for a spouse who doesn’t have income. The main restrictions are that the couple must have at least as much income as their total IRA contributions each year, and that they must file their taxes jointly.
Do you have a child who works part-time or during the summer? Are they just starting out in their career, without anything to spare for an IRA? You may fund it for them, so long as they earned at least $6k last year. $6k is within the gift tax reporting exemption, and given that they can’t touch this money until retirement, if you have the means there is every reason to give your kids a head start.
Whereas Traditional IRAs shelter income from taxes today but generate taxable income in retirement, Roth IRAs are funded with after-tax dollars and generate no tax liability in retirement. They also have no required minimum distributions, allowing all of the money to stay invested as long as you live. Which is better depends on your tax rate now and your expected tax rate later. Low-earners who will likely be well-off in retirement should go with a Roth, and high-earners should go with a Traditional.
But what about a high-earner who is having a low-earning year? Or a modest earner on the way to high earnings? Such cases are perfect for converting some or all of a Traditional IRA to a Roth. The amount converted is subject to income tax in the year of the conversion, but that is the last tax ever owed. Say you have been earning a high salary and sheltering IRA contributions from 32% tax using a Traditional IRA. Now you’ve decided to start your own business, and your income is low so far. You can start a Roth with funds from your Traditional IRA, taking advantage of your temporarily low tax bracket. The conversion amount is considered income, so obviously it’s pointless to convert several hundred thousand dollars and incur 30-odd percent tax, but if you have no other income that year, as a married joint filer you could convert up to $171k before breaking above the 24% bracket. As another example, say you are a low-six-figure earner on the way to the 32% bracket and up. If you have room to go before you top out the 22% or 24% tax bracket, consider doing so with conversions from your Traditional IRA. Just make sure that you have enough cash on hand from other sources to pay the tax when it’s due, as you can’t use IRA funds to pay IRA taxes.
Self-employed high earner? Small company? How about a $57k deduction?
The SEP IRA is a tax-deferred plan that must be set up at the employer level, much like a 401k, although far easier to manage. As with a 401k, the contributions come from the employer, not the account holder. As a self-employed person this is straightforward, and for an employer it is still simpler and more flexible than a 401k. SEP contributions must be the same percentage of income for each employee in the plan, up to 25% or $57k per year. They don’t have to be the same percentage every year, and they can be zero some years. Tax-wise, SEP contributions reduce the company’s taxable income and are not taxable for employees. Once invested, the money grows tax-free until withdrawn in retirement and taxed as ordinary income at whatever your rate is then, like a Traditional IRA. It is the vastly higher contribution limit that makes SEPs attractive for the self-employed or small companies with high-earners. Just a few years of big contributions early in your career could set your SEP on track to fully take care of you down the road.
Don’t forget about regular investment accounts
IRAs are great for retirement, but most of life happens before then, so don’t forget to continually invest in taxable accounts. This should be money that you don’t need for near-term living expenses, but it need not be squirreled away forever. Your investment account will earn a far better rate of return than any bank account, so it is worth tolerating the relative volatility. The strategies we manage are designed to have far lower volatility than conventional portfolios, so you can have greater confidence that the funds will be there when you need them. So max out your IRA first, but set up auto-deposit for your regular account as well.
As always, feel free to reach out with any questions to make sure you’re doing everything right in 2020.