3 Moves to Make in Your Retirement Accounts Before the Year Ends
Consider checking these action items off of your year-end to-do list to reduce taxes and increase your retirement savings.
It happens every autumn: the year-end countdown to make tax-deferred contributions into—or, in some cases, take distributions from—your retirement plans including IRAs and 401(k)s. Here's a checklist of actions you should consider taking before the New Year begins.
1. Boost Your Contributions
Putting off spending to save for retirement is a prime example of delayed gratification and, when you are ready for retirement, you'll be glad you contributed as much as you did. One of the most common regrets of people nearing retirement is failing to save and contribute more to their retirement plans while they were working. You need to be proactive in securing your retirement since time flies and people reach retirement age sooner than they think possible.
For 2016, if you're younger than 50, you're allowed to put $18,000 into your 401(k). If you're 50 or older, you may contribute up to $24,000, excluding whatever your employer matches. The opportunity to max out your contribution for the year vanishes on December 31, and you can't make catch-up for contributions in future years like you can with your IRAs. (Also, you have until April 17, 2017, to make 2016 contributions to your IRAs.) So carefully examine your spending to see if you can squeeze out a little bit more for 401(k) contributions, which come directly off your taxable income unless you use an after-tax Roth 401(k).
If your company has a Roth option, you can direct all or part of your contributions there. Contributions that go into Roth accounts are on an after-tax basis, meaning the contribution does not reduce your taxable income like a regular 401(k) contribution does. Your employer is not allowed to deposit the Roth match into the actual account but has to match it inside of a regular tax-deferred 401(k).
2. Consider a Roth Conversion
A Roth conversion is when you transfer money out of your traditional IRA—which has mandatory required minimum distributions (RMDs)—into a Roth IRA, which do not have RMDs. Since the conversion is taxed, money going into the Roth, as well as the earnings, will not have an RMD nor be subject to further taxes when done correctly. People can do this prior to reaching 70½ years old to reduce RMDs.
Too many people instantly dismiss Roth conversions because they aren't working or they think their income is too high. However, there are different sets of rules for a Roth contribution and for a Roth conversion. For a Roth contribution, you must have earned income below a certain threshold. For a Roth conversion, since the funds already live in an IRA, converting them to a Roth IRA is not subject to those rules. Any conversion you want counted for this year must be completed by December 31.
3. Make a Tax-Free Distribution for Charity
Once you reach age 70½, some of your retirement accounts require that you start to liquidate them, as noted earlier. If done correctly, you can directly contribute all or part of your RMD to a qualified charity. Best of all, the contribution is tax-free and counts as an RMD. Normally, you would make your charitable contributions by the end of the year to receive a tax deduction. I consider this to be immeasurably better since it's a tax-free contribution to a charity of your choice.
There is, of course, a specific way this must be done in order to be tax-free. You must be 70½ and own an IRA. (SEP or Simple IRAs are not eligible; an inherited IRA is eligible as long as you are at least 70½; Roth IRAs are also eligible, although the tax benefit may be negligible since Roth IRA distributions are designed to be tax-free anyway.) You also must not have taken your RMD for 2016.
There has been a lot of confusion about qualified charitable deductions (QCDs) in recent years because they had been allowed and then not allowed. After being bounced around like a ping pong ball, the QCD provision was made permanent last year.
One major caveat: You can't take all RMDs yourself and directly donate them to the charity. Doing so would cause a 1099 to be issued, and the charitable contribution would be classified as a deduction instead of being tax-free.
A good course is to have your IRA custodian transfer the RMD funds directly to the charity. That, of course, requires the charity to provide its account information so you can provide it to your IRA custodian. The custodian then directly wires or sends that part of your RMD directly to the charity.
If your IRAs are large enough, you may donate up to $100,000 per person tax-free for 2016 by December 31. For a married couple, that could be as high as $200,000.
It's a great year-end plan: you can make your charitable gift in a timely manner and finish out the tax-free RMD. It is a win-win for all parties.
Nancy Fleming, CFP®, is the president of Fleming Financial Services, based in Gilbert, Arizona. She is an Investment Adviser Representative and licensed insurance professional.
Kevin Derby contributed to this article.