Even though 2020 is over, you have time to implement a few retirement planning tax strategies that can impact your income tax liability due on April 15. These strategies can help you now, and also set you up for a successful 2021. This article is short, sweet, and to the point—even though you have time to make some of these moves, you’ll want to discuss them with your tax professional to make sure they are appropriate for your personal situation.
Retirement Planning Tax Strategies You Need to Know
1. Max out your IRA contributions.
Contributing the maximum amount allowed to your traditional IRA or Roth IRA every year is a great retirement planning tax strategy and offers additional benefits. All contributions into your IRA reduce your taxable income and reduce your income tax burden at the end of the year. Your annual IRA contributions also help build income in the account to reinvest, you’ll earn tax-sheltered income on any gains, and compound interest on your investment gains works over time to grow additional income in your IRA.
If you did not contribute the maximum allowed into your IRA last year, you still have time to make a contribution that will count for 2020. Traditional and Roth IRAs allow contributions in 2021, until April 15, that can be earmarked as a 2020 contribution. The annual contribution limit for both plans is the same: $6,000 per year, with a catch-up contribution of $1,000 if you’re 50 years or older.
The same goes for maxing out your 401(k). Whether you have a 401(k) with your employer or an individual account, maxing out your contributions every year is the best strategy to build income for retirement.
2. Open and fund an IRA.
If you don’t have an existing IRA, you have time to open one and make a contribution to reduce your tax liability. You have until April 15, 2021 to open and fund a Roth or traditional IRA and make a contribution for 2020. However, you must make sure you designate your contribution is for 2020 when you make the contribution. Your tax and/or financial professional can help ensure you do this correctly.
3. Make sure your IRA contributions do not exceed the annual limit.
It is possible to contribute more to your IRA than the IRS allows. Thankfully, provided you catch this error before you file your taxes, you can make corrections and avoid the 6 percent penalty for excess contributions. It’s critical to catch this mistake before you file your income taxes for the year—otherwise, you’ll be charged that penalty every year until you correct your mistake. You have until your tax filing date, plus extensions, to remove the excess amount contributed. So, if you exceeded your IRA contributions in 2020, you have until April 15, 2021 or October 15, 2021 (the extension deadline) to remove that excess amount.
4. If you didn’t take your RMD in 2020, your RMD in 2021 will be higher.
The CARES Act included a provision that allowed retirees to forego taking their RMD in 2020 if you didn’t need that money last year. This also helped reduce your 2020 income and tax liability. However, that was a one-time provision—so you are required to resume taking your RMD in 2021. You must understand that your 2021 RMD may be a bit higher than you expect. When you resume taking RMDs in 2021, the amount of your RMD is based on the year-end balance as of December 31, 2020. If you didn’t take one in 2020, chances are, your retirement plan balance is higher since you left that income in your account. A higher RMD means your 2021 income may be quite a bit more than you projected. Check with your tax professional to ensure you withdraw the correct adjusted amount and so you’re prepared for an increased tax bill when it is time to file taxes for 2021.
5. Open a self-directed IRA and invest in alternative assets.
Self-directed IRAs offer a unique retirement planning tax strategy that can help you in several different ways.
- You can use alternative investments instead of stocks bonds to build income.
- Account owners choose assets they personally know and understand.
- Income in the account grows tax-free (Roth IRA) or tax-deferred (traditional IRA).
Pro tip: You can also self-direct a 401(k) to maximize retirement plan savings if you own a small business or are self-employed.
Two examples of how self-directed accounts can help you minimalize tax liability now and in retirement:
If you buy and sell real estate investments in your IRA, income—including capital gains from the investment property sales—is deposited directly into your IRA. If you use a Roth, that income grows tax-free in your account, and you won’t owe taxes when you take distributions in retirement. If you use a traditional IRA, the income grows tax deferred and you’ll pay tax on it when withdraw it in retirement.
If you trade bitcoin and other cryptocurrency in your IRA, it works the same as real estate. This is a big benefit when it comes to investing in crypto. For instance, if you personally invest in Bitcoin or other crypto, you must report all gains on your tax return. You are also required to report goods or services you purchase with cryptocurrency. Maintaining proper records for tax-reporting can be extremely time consuming. But, if you invest in crypto with your self-directed Roth or traditional IRA, your gains enjoy the same tax-sheltered status stated in the above real estate section.
Bitcoin and real estate are not the only assets you can invest in using a self-directed IRA. There is an incredibly large pool of investments permissible in these accounts that allow you to invest out of the Wall Street box to earn retirement income.
6. Open a health savings account.
Health savings accounts (HSAs) are fantastic tools that can generate income to help you pay medical expenses today as well as when you retire. Your contributions to the account are tax deductible, which does help you further reduce your annual income tax liability. Plus, because account balances rollover year after year, you could end up with quite a tidy next egg when you retire. HSA funds keep you from dipping into your actual retirement income when unexpected and potentially costly health issues arise.
Once you turn 65, you can withdraw funds from your HSA to use for anything—not just medical costs. You will have to pay tax on those withdrawals, but there won’t be a penalty for using those funds for non-medical purposes. This ability has the potential to greatly supplement your retirement income so that you can truly enjoy your golden years.
Pro tip: You can also self-direct an HSA.
Self-directed HSAs work the same way self-directed IRAs work, allowing you to choose and use alternative assets to build wealth in the account.
The above are just a few retirement planning tax strategies you can use to your benefit to help reach your investing, retirement, and tax planning goals. Always consult with your tax professional for help navigating tax rules and strategies that apply to you.
If you have questions about alternative investments and the advantages of self-directed retirement and other savings plans, please contact Advanta IRA today.