This article was last updated on November 13
In this article we will discuss Retirement Plan Contributions and Conversions and how these can reduce your taxable income in the current tax year. The last business day of 2016 is December 30th, so there is still time to make changes to your contributions to achieve the greatest reduction in your tax liability. The countdown to the New Year is more than just a disco ball being dropped in Times Square. The countdown has a whole different meaning to those who need to maximize their contributions. Time is running out, the time to make tax changes is now.
Contribute to a Workplace Retirement Plan
As soon as your employer allows changes for next year’s retirement plan contributions, you should increase your allocation to the 401K plan that your employer has to offer. This will help you maximize your return. Your taxes will be reduced by multiplying the total amount you contributed to your 401K for the entire year by your marginal tax rate. For instance, if your annual income places you in the 28% tax bracket, you have the opportunity to mount an additional $280 in savings for each $1000 increment that you contribute up to your annual limit of $18,000. As a side note, if you are 50 or older, your maximum annual limit is $24,000.
If you allocate funds to a traditional IRA or a Simplified Employee Pension IRA, you have similar tax advantages. The primary difference is that you have until April 15, 2017 to contribute to a plan and make a difference on your 2016 Income Tax Return. For this type of account, there is also a difference in the annual limit your are allowed to contribute. For taxpayers under age 50, you may only place $5,500 into a traditional IRA. Individuals 50 and older have an annual contribution limit of $6,500. Self Employed individuals may contribute a maximum of $53,000 or 25% of their eligible income, whichever is less, into a Simplified Employee Pension IRA.
Finally, one last savings secret to share for those Retirement Plan participants. If you are near the bottom of your tax bracket, it may be a beneficial move to roll your traditional IRA into a Roth IRA. While you will need to pay taxes on the rollover amount this year, the tax free disbursement of the Roth IRA when you retire will far outweigh the tax hit you will incur right now.
There are two things to consider when rolling over a traditional IRA to a Roth IRA account. First, you have to make sure that the amount you rollover does not exceed the income amount in your current tax bracket. Second, treat all of our Traditional IRA’s as one account, regardless of how many you will be rolling over. You will want to rollover from accounts that have the highest after-tax contributions to received the biggest tax advantage now.
Here is a listing of the current tax brackets so that you can make a completely informed decision regarding your own Roth IRA rollover benefits:
Example: Sally and John have traditional IRA accounts that they wish to convert to Roth IRA accounts that have a combined value of $100,000. The total from these accounts that is from after tax contributions is $35,000. Their taxable amount for this transfer would be 65%. So, if Sally and John wanted to convert $10,000 to a Roth IRA account, their taxable amount would be $6,500.
To figure the taxable amount: 100% – (after tax contributions/total account balance) x 100.
Health Savings Account (HSA)
You also are eligible to reduce your taxable income by enrolling in a Health Savings Account (HSA). If you participate in a high deductible health plan, you are able to contribute a maximum of $3,350 annually if you are a single taxpayer and $6,750 annually if you are a family. Individuals 55 or older also have the opportunity to contribute an additional $1,000 on top of these funds.
Having a Health Savings Account has triple tax benefits. When you make contributions to the account, the contribution is generally made via pretax dollars. Your earnings from these accounts are also federal and state tax free. The withdrawals you make from the account for qualified medical and health care expenses are also tax free. You may receive a tax credit on your IRS return if you make your contributions with after tax dollars.
Health Savings Accounts are not subject to the “use it or lose it” rule. You may use these accounts to pay future qualified medical expenses because your balance at end of year will rollover to the following year. You can also take the balance of the account with you, should you depart from your employer.
It is crucial to plan ahead for your 2017 Health Savings Account. If you anticipate you will increase your qualified medical spending in the upcoming year, you will want to increase your annual contribution. Let’s say you anticipate spending an additional $2,000 in co-pays and prescription payments next year. If you already have an account balance of $3,000, you will have an anticipated $500 in tax savings simply by increasing your Health Savings Account to $5,000.
If You are 70 ½ Years of Age, Make Those Required Minimum Distributions Annually
If you are age 70 ½ or older, it is vital that you make your required minimum distributions (RMD) every year from your traditional IRA or 401K accounts. If you don’t, you are facing stiff tax penalties. You must make your minimum distribution by December 30, 2016. The only exception is if you turned 70 ½ during the course of this year. If you fall into this category, you have a grace period deadline of April 1, 2017. Bear in mind that if you do not make this year’s distribution by December 30th, 2016, you will face taxes due for both years when you file your 2017 Income Tax Return. To avoid this dilemma, you should advise your account administrator that you want automatic withdrawal from the retirement account on a regular basis, either a lump sum for the year, or installments.