Julie has been saving money for years from her paycheck. She has a checking account at her local bank where her paychecks are automatically deposited every two weeks. She pays her bills out of this same account. She makes more than she spends every month, and her bank balance is over $150,000. Julie is wondering if there are better places to invest her money that could help her save on income taxes and allow her to buy investments.
For starters, her employer offers a 401(k) account and matches 100% of employee contributions up to 4% of annual income. Julie earns $70,000 and will be getting $2,800 every year in “free money” by participating in the 401(k) and contributing at least 4% of her salary.
For 2022, you can contribute up to $20,500 to a 401(k) if you are under 50 and $27,000 if you are 50 or older. Contributions to a 401(k) are generally made through payroll deferrals. Contributions to a traditional 401(k) account reduce your taxable wages for the year, and investment earnings grow tax-deferred, meaning you do not report the investment income each year on your tax return. While this saves you taxes currently, future withdrawals are fully taxed as ordinary income.
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If you choose the Roth 401(k) option, your contributions will be taxed currently, and future withdrawals, including all investment earnings and growth, will be tax free.
Putting all of your savings into a company 401(k) is not recommended. You always want to have some accessible savings for emergencies and large purchases. Funds in 401(k)s are intended for retirement, and you must wait until age 59½ before you make withdrawals, or a tax penalty is assessed.
Traditional and/or Roth individual retirement accounts (IRAs) are also good options. The maximum amount that you can contribute to an IRA (traditional or Roth) in 2022 is $6,000 if you are under age 50 and $7,000 if you are 50 or over. Not everyone can put money into a Roth IRA because the ability to contribute to this type of account also depends on your income.
Traditional IRA contributions may or may not earn you a tax deduction, depending on your income. Contributions to a Roth IRA are not deductible, and the account grows tax-free as long as you do not make withdrawals for five years.
Julie should also consider utilizing a taxable brokerage account. You do not receive a tax deduction for contributions to a taxable brokerage account, and the interest, dividends and capital gains generated from the investments it holds are reported on your tax return each year. You also report any investment losses generated, and this can be an advantage. Being able to harvest losses allows you to offset gains from the sale of investments currently and carry over losses to future years to offset gains down the road.
All these rules may seem convoluted (they have evolved out of multiple changes to our tax law), but the underlying intent is to encourage you to save and invest for your retirement. At the same time, Congress wants to make sure you pay taxes now and in the future.
Connie Brezik is a Casper-based wealth advisor with Buckingham Strategic Wealth. If you have a question or topic of interest you would like to see addressed in this monthly column, please email her at [email protected] This article is for informational and educational purposes only. Individuals should speak with a qualified financial and tax professional based on their own circumstances.