The year is winding down. As you wrap-up 2016 business, it’s important to consider saving your extra earnings in a tax-advantaged way when feasible. If you spend less than you earn, there are several ways to shelter earnings from taxes.
Starting with the most time-sensitive plans…
1. Employer Plans include a 401(k), 403(b), or 457(b) plan. Employer-sponsored plans benefit savers in two ways: for one, they are convenient way to save via your paycheck withholdings. Second, many employers offer contribution matches. If your employer offers a matching contribution, make sure you take advantage of the opportunity. It’s basically free, tax-deferred income.
In addition to receiving the company match, you get the added potential benefits of any tax-deferred growth and compounding returns. Many employer plans now offer a Roth option which provides tax free earnings growth as Roth 401k withdrawals are not taxed. Roth IRAs are further described below, but an important difference is that a Roth 401k contribution does not have any income limitation which may otherwise prevent higher wage earners from contributing. Finally, if you are not currently maximizing a contribution to your employer sponsored plan, you’ll need to act soon as you have only until your last 2016 paycheck to make a 2016 contribution.
2. SIMPLE IRAs and SIMPLE 401(k) plans are generally associated with small businesses. If your company offers an employer plan listed above, you will not be offered a SIMPLE. SIMPLE contributions grow tax deferred similarly to traditional IRAs which are discussed in the next section. Income taxes are owed when you make withdrawals. You can contribute up to $12,500 (for 2016) to one of these plans; individuals age 50 and older can contribute an additional $3,000 (for 2016). SIMPLE 401(k) plans can also allow Roth contributions. In order for SIMPLE IRAs and SIMPLE 401(k) plans to shelter tax deferred earnings in 2016, the account must have been established by Oct 1, 2016. However, the employee can contribute through the final paycheck or December 31, 2016 for 2016-eligible contributions. Note: In our experience, SIMPLE IRAs and 401(k)s plans are NOT very common.
3. Traditional IRAs offer a tax deduction up front if you are eligible. Any earnings grow tax deferred, but you pay income taxes on withdrawals. If your spouse or you is not covered by a workplace plan (with exceptions for some 457 plans), you are able to take a tax deduction on traditional IRA contributions.
If you are covered by a workplace plan in 2016, full deductibility begins to phase out at annual modified adjusted gross incomes (MAGIs) of $61,000 for singles and $98,000 for married couples filing jointly. If you're not covered by a workplace plan but your spouse is, then the phaseout begins at $184,000. The maximum contribution is $5,500 per person ($6,500 if you are age 50 or older) or 100% of employment compensation, whichever is less. The deadline for 2016-eligible contributions for traditional IRAs is April 15, 2017.
4. Roth IRAs allow you to contribute after-tax dollars if you have enough earned income and meet certain income eligibility requirements limitations. Any earnings grow tax free, and qualified withdrawals are tax free. In 2016, the max contribution for a Roth IRA is the same as traditional IRAs. But there are income requirements: Eligibility begins to phase out at annual MAGIs of $117,000 for singles and $184,000 for married couples filing jointly. The deadline for 2016-eligible contributions for Roth IRAs is April 15, 2017. Note: you may be eligible for a backdoor Roth IRA contribution which we have written about in the past here.
5. SEP IRAs work in almost the exact same way as a traditional IRA from a tax standpoint but are only available to small business owners. An above the line tax deduction is received by the business for any contributions made, and distributions from the account are taxable as income. SEP IRAs afford a higher contribution limit than Traditional IRAs. For 2016, if you fund a SEP for your business, you are allowed to contribute the lesser of: 25% of your net earnings from self-employment, or $53,000.
Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized. The deadline for 2016-eligible contributions for SEP IRAs is the extended due date of your 2016 income tax return.
Taking Action to Save Taxes in 2016
These savings plans can be confusing. If you need more specialized guidance for which of the above may be appropriate for your individual situation, we recommend you speak to your tax professional. Keep in mind the 2016 deadline for some of these plans is December 31, 2016. So act soon.
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