Tax Planning Part II: Planning for Retirement

By Caroline Alabach

This is a two-part series on end-of-year tax planning. For Part II, we receive advice on retirement planning from financial planner Caroline Alabach. You can find Part I from CPA Chris Davies here .

When I opened my office in Magnolia a number of years ago, my main clientele were people nearing the age of retirement. Today, the tree-lined sidewalks are crawling with families and young professionals who work for the likes of Amazon1, Google2 and Expedia3. Whether it is my more than 20 years in the business or my passion for financial planning, all I can hope for these young people as I see them walking by is that they are saving for retirement and doing it in a tax-efficient way.

If you pick up a magazine or read any article on retirement, they all say the same thing: “start early to take advantage of compound interest and invest in your 401(k).” Sure, that’s the simple route and at the very least you should be saving in your 401(k), but what many people don’t consider is the income tax effects upon withdrawal in retirement.

For young professionals today, between your salary and potential stock options4, you have a lot of income to work with, but you won’t be receiving pensions like your parents and grandparents and you must live off what you save. When you withdraw money from a traditional IRA or 401(k), you pay taxes at ordinary income tax rates. However, there are a number of tax strategies and if you’re paying attention, you can find ways to get dollars into an account where they will be tax-free when you retire.

The first option is to contribute to a Roth IRA, an individual retirement account that offers tax-free growth and tax-free withdrawals in retirement. To be able to contribute to a Roth IRA, you have to make under a certain income threshold; if you are single and make over $124,000 you unfortunately phase out of the option to use this type of account. If you are married and filing jointly, it phases out at $196,000. If you do not qualify under these income stipulations, one option might be to look at a Roth 401(k) option because there are no income limits. For example, if you are contributing $19,500 into a 401(k), you can allocate a portion to invest in a traditional 401(k) where the contributions are made with pre-tax dollars and a portion to be allocated to a Roth 401(k) where the contributions are made with after-tax dollars.’

Another option if your income prohibits you from putting money into a Roth IRA is to perform a backdoor Roth5 contribution. A backdoor Roth is not a type of retirement account, but a method for high-income taxpayers to fund a Roth. The basic steps are this: make a $6,000 non-deductible IRA contribution (post-tax dollars), then convert that IRA amount to a Roth IRA. If you have no other pre-tax dollars or earnings in your IRA, then you will not pay any taxes upon conversion. There are many details in a Roth conversion that need to be reviewed prior to taking action, and it is imperative that you consult with your financial and tax advisor prior to doing so. Contributions are limited, but conversions are unlimited.

To take it even one step further, there is something we call a mega backdoor Roth. This type of contribution is relatively new for some company retirement plans including Amazon and Docusign,6 among others. The maximum amount you can contribute to your 401(k) in 2020 is $19,500 ($26,000 if you are over 50) per year, but some companies’ plans now allow for after-tax contributions beyond these limits. Depending on a number of factors, you can contribute significantly more in after-tax dollars, which will then be converted to Roth dollars (tax free forever).

Traditional IRAs and 401(k)s require that you withdraw a minimum amount, and pay tax on this amount, when you reach the age of 72. Depending upon how you have funded your retirement, you may not be happy with the potentially large tax bill you have created. Looking into and acting upon these Roth options now can provide great benefit in your later years. However, I must emphasize that every situation is unique, so it is worthwhile to consult your financial advisor and tax professional to determine the best mix for you and to avoid any unintended consequences.

My happiest days are when my clients retire from lifelong careers, confident they are financially ready. But confidence comes with preparation, so be sure you are taking advantage of opportunities today.

1 Amazon

2 Google

3 Expedia

4 Employee Stock Options

5 Backdoor Roth

6 Docusign

While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

Roth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal tax penalty.

Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.

Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.