The end of the year is a good time to take a look at your retirement savings situation, and consider whether you're taking advantage of all applicable tax laws to set yourself up for the post-working years.
We asked Melissa Sotudeh, a certified financial planner in the Washington, D.C., area, for some tax-smart tips on retirement savings.
What's the most important thing about tax planning for retirement accounts?
You can control your income tax bracket to some extent by maximizing salary deferrals — for example, by putting as much as possible toward retirement accounts like 401(k) and IRA plans and thereby lowering your taxable income. Otherwise, you need to be as tax-efficient as possible as you save for college, retirement or other goals.
While you're in a lower tax bracket, you may be able to take advantage of certain deductions, such as those for job-hunting or moving for employment, and tax credits, such as the child tax credit and the education credit. You could also contribute to a Roth 401(k), which allows you to pay taxes at a lower rate now and then withdraw your Roth funds tax-free in retirement.
You should also approach your investment strategy as tax-efficiently as possible. This isn’t directly related to tax brackets, but to the tax treatment of investments in your portfolio. Strategies include holding the right investments in the right account (for example, holding tax-advantaged investments like municipal bonds in a taxable account), annual tax loss harvesting, and choosing funds with tax-efficient qualities like low turnover ratios.
What is the biggest mistake people make related to their income and tax brackets?
Not leveraging tax-advantaged savings vehicles before you are phased out is a big mistake. This often happens with Roth IRAs. They are a great savings vehicle, but your ability to contribute starts to get phased out above certain earning limits. For 2017, the Roth IRA income limits begin once you start earning over $118,000 ($186,000 for married, filing jointly). At the $133,000 income level ($196,000 for married, filing jointly) you become ineligible to contribute.
Another big mistake is not using the catch-up allowance for tax-deferred retirement accounts and HSAs, which lets you contribute even more to your retirement account once you reach age 50. If you are able, you should absolutely take advantage of this opportunity to boost your saving and limit your taxable income. The catch-up contribution for retirement accounts, such as 401(k)s, is currently $6,000, in addition to the normal $18,000 limit. That's a maximum contribution of $24,000 per year for people over 50.
Catch-up contributions of $1,000 for HSAs are allowed starting at age 55. This is in addition to the maximum contribution of $3,400 per year for individuals or $6,750 for families.
What other tips should people know about to optimize their tax status?
Charitable contributions via Donor Advised Funds are also a very effective way to manage taxes in a given tax year. With these funds, you can donate money or appreciated assets and take the tax deduction for the charitable contribution in the year you contributed it. However, you don’t have to decide on a recipient charity for your donation in that year. You can leave assets in the fund to grow over time and donate to any 501(c)(3) charitable organization at any time.
Whatever your investment strategy, tax planning must be considered in order to minimize investment taxes.