Saving Resolutions for 2021
As the new year rolls in, many reflect on the goals and resolutions they want to make. Sometimes, money, planning for retirement, and accumulating wealth are on the list. If it’s on your list…read on.
The most obvious first step is to spend less than you make and make sure your lifestyle doesn’t constantly creep up at the same rate as your income or wages. This is critical because over time you’ll want to increase the ability of your savings. The next step is to prioritize saving opportunities as they relate to you and your situation and focus on maximizing each opportunity.
Your Company Employer Plan:
Many workers are eligible to participate in a 401(k), or similar vehicles like a 403(b), 457, and Simple IRA. All are similar in that employees are eligible to defer a portion of their salary and invest the proceeds for their retirement. In Traditional 401(k)s these contributions lower your current taxable earnings. At retirement or when you make withdrawals, you’ll pay taxes based on your ordinary income tax rate at that time.
Some companies match or contribute to these plans balances as well. Generally, your first goal should almost always be to maximize your contributions to these plans. For those under age 50, the annual limit for 2021 is $13,500 for a Simple IRA and $19,500 for the other plans listed. For those over 50, the 2021 limits are $16,500 and $26,000, respectively.
For workers and avid savers that are in higher tax brackets today and will likely be in retirement (or those who believe tax rates will go up rather than down), it may be wise to consider foregoing the traditional tax-deferred contributions and opting for Roth Contributions to the plans listed above (if your plan offers this choice). If you fund the Roth plans versus the Traditional plans, your taxable earnings are not reduced, and you’ll pay taxes on your contributions today. The benefit is that once funds are in the Roth, all your contributions and earnings can be withdrawn tax-free at retirement if you wait until you are 59 ½ and the accounts have been opened for at least 5 years.
(I choose to fund Roth over Traditional as I’d rather pay the taxes on the contributions today so that everything is tax-free in the future. Think of it as paying taxes on the seedling so you can enjoy the harvest tax-free.)
Individual IRA’s and Roth IRA’s:
For those that have maximized their company or employer plan, or don’t have a plan available, the next step is to review your Individual options. Here things get a little trickier as contributions are limited based on income, whether you are married, and if your spouse has a retirement plan. Generally, the contributions are limited to $6000 under age 50 and $7000 for those 50 and over in the calendar year. More advanced and eager savers may even consider Back Door Roth IRA/Roth Conversions to get more funds invested tax-free. This isn’t hard but requires a little knowledge, a few extra steps, communication with your tax preparer, and understanding your current IRA situation. In the end, anytime you can do something tax-free I say, “Go for it.”
(Again, I fund a Traditional IRA and subsequently convert it to a Roth IRA annually. Also, I do it at the beginning of each year to benefit from the extra 12 months of growth.)
Self-Employed and/or Individuals with outside 1099 Income:
Here is where motivated savers can really juice things up and have multiple options.
Individual (k) aka Ind(k): For those with self-employment income, this is a great way to add additional funds for retirement. The plan works like the employer plans mentioned above, but now you’re both the employee and employer. Employees can contribute a portion of their pay ($19,500 to $26,000 depending on age) and then the employer (yourself) can contribute additional amounts up to a combined maximum of $58,000 for 2021. Employer contributions are always tax-deferred, but the employee portion can be Traditional or Roth like those described above in “Your Company Employer Plan.”
Personal Pension: If significantly reducing current tax liability is a priority, a Defined Benefit Plan or Cash Balance Plan can be considered. They are the most complicated and expensive of the retirement savings tools mentioned so far, but these plans allow for significant tax deferral. Savers in their 40s may be able to defer between $80k-120k, while those closer to retirement may be able to put away $200k-300k. The contribution amounts depend on your net self-employment income up to a maximum recognized salary of $290k per IRS rules for 2021. If you have employees, increased retirement plan contributions are necessary to pass retirement plan testing requirements established by the IRS and Department of Labor. If you have no employees, you’ll receive the full benefit a personal pension plan offers.
After-Tax Savings:
Okay…so you are really motivated and have done all the allowed saving techniques and still want to save more. Now it is time to open an “after-tax” or “non-qualified” investment account(s) where you can save after-tax funds while seeking tax efficiency. Investors in higher tax brackets should consider Municipal bonds where the interest/dividends are tax-free. For residents in California, income paid by California municipalities and territories like Puerto Rico is generally free from both state and federal income taxes. Want to be a little more aggressive? Then consider investing in stocks. Dividends and capital gains receive preferential treatment for Federal income tax purposes (lower tax rates), and capital gains can be postponed into the future. If a stock is held for at least a year when gains are realized, the tax rates are more favorable (currently 0%, 15%, or 20% for federal taxes depending on your Modified Adjusted Income). Unfortunately, there are no California favorable capital gain rates; all earnings are taxed as ordinary income. However, if you never reap the gains while alive and pass away, the gains are stepped up (under current law), and all goes tax-free to your spouse or beneficiary.
Time:
Time is your best friend. The more time you have the easier it is to accumulate wealth. Small but frequent investments early in life really add up. Compound interest (interest on interest) has been defined by some as the 8th “Wonder of the World”. Even if your time is shorter do not give up. Make a commitment to save and invest for your future. When you get your next pay raise, set aside a portion of the increase for your savings and then enjoy the rest.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.