The “ages and stages” method of investing and financial planning used by most advisors tends to be gradual and loosely-defined: generally move to a more conservative asset allocation as clients get older, decide when to take Social Security, and so on.
But the tax code contains certain specific ages that trigger new opportunities and potential pitfalls, especially for clients who are saving for (and then spending in) retirement.
Start Saving More
Turning 50 might make clients feel “old” for the first time, but the dismay over that age can be offset by the chance to increase the amount that those who are working can save for retirement each year.
Employees who participate in retirement plans at work get the biggest benefit. For 2014 the contribution limits for 401(k) and 403(b) plans are $17,500 for those under 50. But those who are 50 and over can defer up to $23,000 of their earnings into 401(k)s, 403(b)s, or the Roth versions of each.
SIMPLE IRA participants over 50 also get the option to ramp up their retirement savings, as the annual limit jumps from $12,000 to $14,500.
Then there are the benefits for depositors to IRAs and Roth IRAs. For the 2013 and 2014 tax years, the deposit limits are the lesser of the worker’s earnings, or $5,500. However, those over 50 can deposit up to $6,500 for each year, as long as their earnings exceed that amount.
Don’t forget the opportunity to save for a non-earning spouse. As long as the stay-at-home partner is over 50 and the couple files jointly, another $6,500 can be contributed to an IRA or Roth IRA on his or her behalf, as long as the rest of the couple’s income is within the income parameters and limits.
In fact, it may be possible for a couple to deposit money into a tax-deductible IRA for a non-working spouse, even if the working spouse contributed to a retirement plan at work. Check Publication 590 at www.irs.gov for more information.
Why Save More?
In theory, the ability to increase money deferred into retirement account will of course lead to more spendable funds once the clients retire. But the advantages can be more subtle and immediate.
First, saving more now may force the clients to adjust to living on a little less, which can be a key component to achieving a secure retirement. Yet the money they’re foregoing is still theirs to use, and they are generally free to reduce or eliminate their deferral amount at any time.
Dollars deferred into pre-tax retirement plans also provide an immediate benefit in the form of a lower tax bill due on April 15. And of course any future earnings on investments held within the plans are sheltered from taxation as well.
Any future withdrawals from tax-deferred accounts are eventually going to be considered taxable income.
But the majority of clients will likely be in a lower tax bracket when they retire, and therefore will pay a lower rate on the withdrawals than what they would have paid on the deferrals and investment earnings.
Early Retirement Option
The next important age for would-be retirees is 55. That’s when they can “separate from service” (i.e. quit or retire), and then tap their at-work retirement plans, such as 401(k)s and 403(b)s, for any reason. They could then avoid the 10 percent penalty that would normally be imposed on withdrawals made before the owner reaches age 59 ½.
Of course, any distributions made under this scenario will technically be taxable as ordinary income. But that tax bill is likely to be relatively low, as the client only needs to withdraw enough to cover living expenses.
The taxes can be minimized even further if the client can use non-retirement (and untaxed) savings to pay for some of their costs in retirement.
Some clients who have this option may still be rightfully concerned about funding an early retirement solely from savings. But they may be soothed by the notion that within a few years their withdrawals can be reduced by whatever they might receive from Social Security.
Note that the option of tapping a retirement account free from penalty while under age 59 1/2 is lost if the entire balance of their at-work retirement plan is moved to a self-directed IRA. Therefore it may be a good idea to leave at least a portion of the funds in the 401(k) or 403(b), if possible.
As soon as clients turn 59 ½, they can generally withdraw money from retirement accounts for any reason without paying the 10 percent penalty. But this break comes with a couple of caveats. Although there is usually no penalty on the withdrawal at this age, any money pulled out will be taxable as ordinary income, unless it’s from a Roth IRA.
Contributions to Roth IRAs can be withdrawn at any time for any reason, with no taxes or penalties whatsoever. But the earnings portion of the account is another story. Even if the client has reached age 59 ½, taxes and penalties may be imposed on the “earnings” portion of a distribution from a Roth IRA if it’s been less than five years since the client first made a deposit to a Roth IRA.
Since the “clock” for this five-year provision begins ticking as soon as a client makes her first Roth IRA contribution, it’s imperative that you prod any eligible clients to make their Roth IRA contributions as soon (and as often) as possible.