Retirement Savings & Reducing the Tax Burden

Saving for retirement is something most Americans understand is of vital importance. Yet often investors are confused about the best places to save for retirement. The answer in most cases is not one or the other, but rather multiple places. The determination of what vehicle is utilized first is often dependent on your tax status.

Employer based retirement plans in most cases are the first place to begin. These are typically referred to as defined contribution plans. They are 401k’s / 403b’s / deferred compensation plans…etc. The key benefit is that in most cases contributions to these plans enter on a pretax basis. In the case of a 401k plan there is often an accompanying employer matching contribution. The pre-tax nature reduces the Adjusted Gross Income (AGI) of the individual. The reduction in AGI not only reduces the tax liability on the dollars contributed, but also may generate other benefits. A reduction in AGI will lower an individual’s exposure to the dreaded Alternative Minimum Tax which is assessed on an individual’s AGI rather than their gross income.

IRA contributions can also yield some significant tax benefits and are usually the second place to look. An additional benefit to reducing the AGI by the amount contributed is it may also permit an individual to contribute to an IRA in addition to their employer plan. IRS rules state that in the Year 2014 in order to qualify for a deductible IRA contribution when covered by an accompanying employer sponsored plan, you must have an AGI below $60,000.00 for a single filer and $96,000 for a couple filing jointly. AGI above those levels begin to partially phase out the contribution and eventually completely phase it out. Alternatively, if your income is too high for the deduction and you wish to contribute to a ROTH IRA and capture the tax free growth…the incomes rules are as follows. And investor must have an AGI below $114,000.00 for a single filer and $181,000.00 for a joint filer before the phase outs begin. So the reduction of AGI is also important when it comes to utilizing the maximum IRA contribution.

In the case of someone whom is self-employed, there a number of options that can be utilized to substitute the lack of an employer provided plan. Creating your own employer plan to reduce your AGI is specific to the type of business you have in relation to the number of employees. In cases where the individual is a sole employee or employs only family, they may want to consider multiple options such as a self-employed 401k plan / SEP IRA / Defined Benefit Plans…etc. When there are employees to consider the rules begin to get a bit more complicated. A census must be taken by an actuary and benefits testing must be done to determine what plan or combination of plans is most tax efficient. They may include 401k’s/ Defined Benefit Pension Plan’s / Cash Balance Plans and numerous other possible combinations. Each of which provide a similar benefit in terms of reducing one’s AGI.

Once you have maximized the above referenced options, another place you can reduce your AGI is via the Health Savings Account. These accounts are commonly offered by employers as mechanism to pay for out of pocket medical expenses such as deductibles and co-payments. Each dollar contributed reduces an individual’s taxable income and can be distributed throughout the year to cover these ongoing medical costs tax free, giving the HSA account characteristics of both a Traditional and ROTH IRA. The funds rollover each year if not spent in the year contributed. The dollars contributed to the HSA can also be invested similarly to a retirement account until withdrawn. While this is not a traditional retirement savings vehicle, it can still be viewed as one considering that healthcare related expenses will be part of an investor’s budget in perpetuity. And in fact at age 65 an HSA essentially converts to the equivalent of a Traditional IRA, at which point you can begin to withdraw money penalty free. However, the funds will be taxed if you do not continue to use them for qualified medical expenses. In the year 2014 the maximum HSA contribution is $3,300.00 for a single filer and $ 6,550.00 for a couple filing jointly. It should also be noted that similar incarnations of the HSA accounts can be drafted for self-employed individuals.

Assuming an individual has maximized their employer drive qualified plans and/or the IRA contribution, they may want to inquire as to whether or not there is a non-qualified plan available as a 3^rd option. In a non-qualified deferred compensation plan the employer permits employees to contribute as much as 50% of their income on a pre-tax basis to shelter form taxes. This has a similar effect as a traditional 401k plan. However, these plans should be utilized with great caution. In the case of a non-qualified plan, the assets in the plan are considered to be assets of the company until distributed to the beneficiary of the plan. In the event of the company filing for bankruptcy the assets within the plan would be subject to the organizations creditors, whereas this is not the case in a 401k or other qualified retirement plans. Additionally non-qualified plans do not offer the same degree of flexibility when it comes to distributing assets. In most cases the plan must be liquidated after separating from service with the employer over either a 1, 5, 10 year period or a specific date. So the ability to control the tax liability upon distribution is a bit more limited. Self-employed individuals can also draft their own non-qualified plans. In such cases there is a greater degree of flexibility as you exercise greater control over things like the separation from service.

Saving for retirement can be complex enough to the average investor when just looking at the type of accounts available and where they should first direct their contributions before they even begin to examine their actual investment options utilized within each plan. As in all aspects of financial planning, it is important to look at each scenario on a case by case basis to determine what options are most suitable for you.