Even in a world of uncertainty, taxes are inevitable. The good news is there are many ways to significantly reduce the amount of taxes you owe so you can save more for retirement.
Here are two great ways to start accumulating more tax-free retirement savings:
1. If Your Spouse Doesn’t Work, Establish a Spousal IRA:
Under normal circumstances, an individual who desires to contribute to an individual retirement account (IRA) has to earn income to do so. But if you are a nonworking spouse, an exception is granted and your working spouse can establish a “spousal IRA” on your behalf.
With such an account, the working spouse can contribute up to $5,500 on an annual basis to the spousal IRA (or $6,500 if the nonworking spouse is over the age of 50) in addition to their contributions in their own retirement accounts. Keep in mind a married couple must file a joint tax return to qualify. In addition, it is important to consider whether the spousal IRA should be a traditional IRA or Roth IRA.
Taxes on Traditional and Roth IRAs
With a traditional IRA, you are able to deduct the contributions to the spousal IRA from your income, thereby reducing the amount of taxes you pay. You then pay taxes when you withdraw money out of your account during retirement (and when you are presumably in a lower tax bracket).
With a Roth IRA, you pay taxes prior to making the contributions, meaning you do not receive an up-front deduction on your income, but you are able to make tax-free withdrawals from your account once you reach 59.5 years of age and have had your account open for a minimum of five years. You can withdraw your contributions from your Roth IRA whenever you want. It is only when you withdraw the earnings or interest your account has earned that you must reach the age and five-year account establishment requirements. (For related reading, see: Making Spousal IRA Contributions.)
If the working spouse earns more than $199,000, direct contributions into a Roth IRA for his or her spouse are not allowed (for a workaround on this, see the next section), so a traditional IRA is the only option. If the working spouse has access to a 401(k) plan at work, contributions to traditional IRA accounts are still allowable, but the working spouse cannot take a tax deduction if his or her income is above $121,000, and the nonworking spouse loses the deduction when household income exceeds $199,000.
Contributions can still be made to traditional IRA accounts regardless of a household’s income, and when withdrawals are made, the couple is only liable for taxes on the earnings accrued on the non-deductible contribution.
2. For High Earners, Make a Backdoor Roth IRA Contribution:
The IRS does not allow individuals who earn over $135,000, or couples who earn above $199,000, to contribute directly to a Roth IRA. That being said, you can still contribute to a traditional IRA, then convert the money to a Roth IRA.
Since you already paid taxes on the traditional IRA contribution, the only tax you owe is on the appreciation the money earns prior to the conversion to the Roth IRA. You therefore need to make sure that you undertake the conversion quickly to limit the amount of time your money can grow and, by extension, the amount of tax you owe on that growth once the conversion takes place.
There is one potential snag, however, with regard to a backdoor Roth IRA conversion. Specifically, if you have other IRAs, a conversion becomes significantly more complicated because the IRS prevents individuals with traditional IRAs containing both pre- and post-tax money from converting only the post-tax money.
For example, let’s say you have $75,000 in a pre-tax IRA from a previous 401(k) your rolled over after changing jobs. If you now put $5,500 of post-tax money into a separate IRA, you are not allowed to convert only the $5,500 tax-free income into a Roth IRA. Rather, you must divide your post-tax contribution of $5,500 by the total amount in both your IRAs ($80,500). This percentage, 6.8%, of the conversion is what the IRS considers tax-free, which means you owe taxes on all but $375.77 of the $5,500 you converted. (For related reading, see: Pros and Cons of Creating a Backdoor Roth IRA.)
You can overcome this obstacle by rolling all of your pre-tax money into your current employer’s 401(k) plan and leaving the post-tax contribution of $5,500 in your IRA, where it can then be converted to your Roth IRA.
You will never entirely escape the tax man, but contributing to a spousal IRA or converting funds from a traditional IRA to Roth IRA can help reduce the amount you owe and increase the amount that stays in your pocket.
(For more from this author, see: Deciding if Term Life Insurance Is Right for You.)