Every year around tax time it occurs to me that most of us can do a better job of setting up and managing our personal retirement accounts for greater ease of administration and long-term effectiveness. Toward that end, here are my favorite “dos and don’ts.” Follow them and your life will be simpler, your future more financially secure.
Yes, you can make that IRA contribution
I never tire of telling people that, yes, you can make an IRA contribution – just as long as you have enough earned income (not investment or passive income). It’s that simple. Yet tax preparers routinely tell their clients that they “can’t” make IRA contributions. What those well-meaning professionals mean to say, of course, is that some IRA contributions are not tax deductible. They assume that if you can’t deduct it, it isn’t worthwhile. Yet while that may be understandable input for last year’s tax return, it’s usually bad investment advice.
IRA contributions that cannot be deducted are called “after-tax” contributions. All earnings in IRAs, however – whether from pre-tax or after-tax contributions – are shielded from current taxation. If you’re a high-earning professional, that alone can be a very valuable benefit of holding a considerable portion of your long-term savings in retirement accounts, like IRAs. What’s more, the fact that you’ve already paid taxes on that money can also be a good thing. If you make a lot of money you probably cannot contribute directly to a Roth IRA. You can, however, convert after-tax contributions from a regular IRA to a Roth IRA, sometimes with minimal or no tax consequences. As a result, the lifetime earnings of these contributions can be completely tax-free for the rest of your life. I’d say that’s a pretty nifty deal, even if you don’t get a current tax deduction for the contribution.
If you do make an after-tax IRA contribution, be sure that you tell your tax preparer and include a form 8606 in your tax return.
The Problem with SEP IRAs
The biggest problem with SEP IRAs is that they’re OK. If you have personal business income (but no other retirement plan) and are looking for last-minute tax savings, a SEP IRA can help. But the fact that they provide a band-aid means that many small business owners don’t bother with solution that’s even better: an Individual 401(k).
A SEP IRA can get you through tax season by giving you a way to save a bit on your tax bill at the last minute. But an Individual 401(k) typically enables much more generous contributions – and tax deductions. Why don’t more small business owners open Individual 401(k) accounts? The answer is almost always a simple matter of timing. While a SEP IRA can be opened (and funded) any time prior to the submission of one’s tax return, an Individual 401(k) must be opened in the calendar year for which the contributions are going to be made. In other words, if you want to make a 401(k) contribution for the 2015 tax year, you needed to have opened your Individual 401(k) account by December 31, 2015. You can’t wait until April 1st, 2016, like you can with a SEP IRA.
But this little bit of procrastination can cost you dearly. Rather being limited to ‘profit sharing’ contributions – which are the same as they are with a SEP – you can also make ‘salary deferral’ contributions to your Individual 401(k). Let’s say you’re 50 years old and are trying to save as much as possible for your retirement. Your Schedule C net income – before retirement contribution – is $50,000. Your maximum SEP-IRA contribution is $9,293.52. Your Individual 401(k) contribution, in contrast, can be as much as $33,293.52. That’s a big difference.
Even if you’re going to open a SEP IRA this year to make the smaller contribution – and get the smaller deduction – go ahead and open your Individual 401(k) account right now for 2016. You can roll your SEP funds into the 401(k) and get rid of the old SEP account. Your life will be simpler and more tax efficient.
Keep it Simple: Don’t Procrastinate
If you want to avoid lots of confusion and wasted time come tax time, I have a final piece of advice: Try to make all your IRA contributions during the tax year in question. While it is possible to make IRA contributions for the previous tax year before the April 15th filing deadline – and it is better than not making them at all – just about everyone I know gets monumentally confused when it comes to accounting for the time-shift involved. First, you have to keep track of the fact that the contribution you made in February of 2016 actually belongs on your 2015 tax return. Then year you need to remember that that same contribution, in February of 2016, does NOT apply to your 2016 taxes. Practically speaking, that’s a lot of remembering for many people.
So if at all possible set up your IRA contributions to be completed during the tax year in question, and be consistent about it. That way, you can rely on the simple rule: if it got contributed in 2015, it’s a 2015 contribution.
And who doesn’t need a little more simplicity – and less confusion – during tax season?