Maximizing Your After-tax Return

By Nicholas Guido, CFP®

November 20, 2018

Prioritizing your Asset to Maximize your Tax-preferred Savings

With all of the tax-deferred, tax-deductible, and tax-free investment accounts that are available to investors how does one know which ones are best for them or even how to prioritize your savings. In this article we will address the primary investment accounts, there benefits, and then how to create the best saving plan strategy for you and your family.

We will start by first outlining the different types of investment accounts, how they work, and their benefits to you.

Single Member Pension – Personal Defined Benefit Plan

A Defined Benefit Plan helps you the self-employed and small business owner save aggressively for retirement by allowing you to make very high contributions. With this type of plan you can target a desired level of retirement income, and contribution amounts are adjusted each year to help you reach your targeted income level. When making contribution to a Personal Defined Benefit Plan the contributions are 100% tax-deductible, within IRS limits, and earnings grow tax-deferred until they are withdrawn.

Benefits:
Substantial benefits can be provided and accrued within a short time period – even when you retire early.

Self-employed individuals or small business owners can contribute, and deduct, more than under other retirement plans.

Vesting can follow a variety of schedules from immediate to spread out over seven years.

In general, the annual benefit for a self-employed individual or small business owner under a defined benefit plan cannot exceed the lesser of: 100% of the self-employed individual or small business owners average compensation for his or hers highest 3 consecutive calendar years, or $220,000 for 2018.

Potential Hurdles

  • Higher cost plan and can be administratively complex.
  • An excise tax applies if the minimum contribution requirement is not satisfied.
  • An excise tax applies if excess contributions are made to the plan.
  • Must file a form 5500 annually.

Contributions

Contributions to a defined benefit plan are based on what is needed to provide a definitely determinable benefit to the self-employed individual or small business owner. Actuarial assumptions are required to determine the contribution levels.

Health Savings Account (HSA)

A health savings account (HAS) is a tax-deductible savings account that is used in conjunction with an HSA-qualified high-deductible health insurance plan (HDHP). HSA regulations allow you to reduce federal income tax by depositing pre-tax money into a health savings account, as long as you are covered by an HSA-qualified HDHP. In 2018, you can deposit up to $3,450 if you have HDHP coverage for just yourself, or $6,900 if you have HDHP coverage for your family. If the account holder is 55 or older they will be allowed to make an additional deposit of $1,000 each year. An HDHP (High Deductible Health Plan) per IRS definition, is a high deductible health plan with a deductible of at least $1,350 for an individual or $2,700 for a family. An HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) cannot be more than $6,650 for an individual or $13,300 for a family.

In addition, to optimize your HSA account, during the contribution periods it is most favorable to cover medical expense from income or outside assets. This will allow your contributions to continue to compound on a tax-deferred basis for a longer period of time.

The Triple-Tax Advantage

  • HSA contributions are pre-tax regardless of your income.
  • No tax on investment gains or interest while the money is in your HSA.
  • Withdraw from your HSA and it is still tax-free; if you use the funds to pay for qualified medical expenses.

Roth IRA

A Roth IRA is an individual retirement account that offers the opportunity for tax-free income in retirement. Both earnings on the account and withdrawals after 59 ½ are tax-free. Annual contributions are taxed upfront and all earnings are federal tax-free when they are distributed according to IRS rules. This is very different from a Traditional IRA, which taxes withdrawals. Contributions can be withdrawn any time you wish and there are no required minimum distributions after age 70 ½ . If you are in a lower tax bracket today than you will be during retirement, a Roth IRA may be a smart choice since you would be paying fewer taxes in the long run. A Roth IRA is also one of the more power savings vehicles available because they do not have required minimum distributions and can pass down to the next generation and withdrawals are still tax-free to the heirs.

Who can contribute to a Roth IRA?

Roth IRA contributions are limited by income levels so you’ll need to check if you’re eligible first. In general, you can contribute to a Roth IRA if you have taxable income and your modified adjusted gross income is either:

  • Less than $189,000 (phasing out at $199,000) for married couples filing jointly
  • Less than $120,000 (phasing out at $135,000) for individuals
  • Less than $100,000 for married couple filing separately

Backdoor Roth IRA Contribution

What is a Backdoor Roth IRA Contribution?

A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA contribution into a Roth IRA.

Contributing directly to a Roth IRA is restricted if your income is beyond certain limits, but there are no income limits for conversions.

The amount of money you can contribute to a Roth IRA is normally limited, but a backdoor Roth IRA has no limits on the amount of the conversion.

This strategy allows individual to take advantage of the tax-free withdrawals of the Roth IRA even when their income excludes them from making direct Roth IRA contributions.

Are there any restrictions or obstacles to the Backdoor Roth IRA Contribution?

Yes, there is the IRA Aggregation Rule under IRC Section 408(d)(2). This rule stipulates that when an individual has multiple IRA accounts, they will be required to treat them all as one account when determining the tax consequences of any distributions. This includes a distribution for a Roth conversion.

Traditional & Roth 401(K) Plans

A 401(K) plan is a qualified employer-sponsored retirement plan that eligible employees make salary-deferral contributions to on a pre-tax or post-tax basis. Employers offering a 401(K) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings will accrue in the 401(K) plan on a tax-deferred basis. Also, depending on the type of 401(K) that you have chosen the withdrawals will either be taxable with a Traditional 401(K) or tax-free with a Roth 401(K).

The benefits and characteristics of each of the 401(K) plan types will be similar to that of the applicable IRA accounts, with the exception of the contributions limits and restrictions. The income restrictions that hold true for Traditional and Roth IRA accounts are not there for 401(K) plans.

How much can I contributed to a 401(K) plan?

The maximum contribution to a 401(K) plan, for both types, is $18,500 per year but if you are over age 50 then you are eligible for a $6,000 catch-up contribution.

When you include the employer contribution the total of all sources cannot exceed $55,000 or $61,000 for individuals over age 50. Even though the total of all sources in $55,000 or $61,000 respectively, the employees’ contribution can still not exceed $18,500 or $24,500.

SEP (Simplified Employee Pension) IRA

A SEP IRA is a type of traditional IRA for self-employed individuals or small business owners. Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Contributions, which are tax-deductible for the business or individual, go into a traditional IRA held in the employee’s name. Employees of the business cannot contribute – the employer does. Like a traditional IRA, the money in a SEP IRA is not taxable until it is withdrawn.

One of the major key advantages of a SEP IRA over a traditional or Roth IRA for a self-employed individual or small business owner is the elevated contribution limit. For 2018 business owners can contribute up to 25% of income or $55,000 per year, whichever is less.

Traditional IRA

A traditional IRA is a type of individual retirement account that allows your earnings to grow on a tax-deferred basis. You pays on your contributions only when you make withdrawals from your account. These earnings will grow tax-deferred until you withdraw them or until you reached 70 ½ and are subjected to Required Minimum Distributions (RMDs). You may contribute up to $5,500 of earned income until age 50, at which time you are given the ability to contribute an additional $1,000 or $6,500 until you reach age 70 ½.

Once you reach the age of 70 ½, you must begin taking an annual Required Minimum Distribution (RMD). These withdrawals are penalty-free and taxed as ordinary income in the year they are withdrawn after the age of 59 ½. If you were to withdraw the funds prior to age 59 ½ the funds would be subjected to ordinary income tax and an additional 10% penalty. A traditional IRA account may be a wise choice if you are going to be in a higher tax bracket now then in retirement. This way, you can benefit the most from the money you put into the IRA if you’re in a lower tax bracket when you retire.

Who Can Contribute?

If you do not have a retirement plan at work and you’re younger than 70 ½, you can contribute to annual contribution limit and deduct the entire amount from your taxes. Also, if you spouse does not work outside of the home, he or she can also invest up to the federal limit and deduct the full amount.

Your contribution will be fully deductible even if your company has provided you with a 401K, as long as your adjusted gross income (AGI) is less than $99,000 for married couples filing jointly, or $62,000 for an individual.

If you have a retirement plan through the workplace the deductibility of the contribution is phased out at $119,000 for married couples filing jointly, or $72,000 for individuals.

If you’re not covered by a workplace plan but your spouse is, your contribution is fully deductible if your combined income is less than $186,000 and gets phased out at $196,000.

529 Plans (College Savings)

A 529 Plan is a tax-advantaged savings plan that was designed to help and encourage family’s savings for their child’s future educational costs. 529 plans are also known as “qualified tuition plans,” are sponsored by states, state agencies, and/or educational institutions and are authorized by Section 529 of the IRC.

There are two types of 529 plans: prepaid tuition plans and educational savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor their own prepaid tuition plans.

What are the Differences between Prepaid Tuition Plans and Educational Savings Plans?

Prepaid Tuition Plans: Prepaid tuition plans let a saver or account holder purchase units or credits at participating colleges or universities for future tuition and mandatory fees at current prices for a specific beneficiary. These plans usually cannot be used to pay for future room and board at colleges and universities and do not allow you to prepay for tuition for elementary or secondary schools.

Prepaid tuition plans are not guaranteed by the federal government. Some state governments guarantee the money paid into the prepaid tuition plans that they sponsor, but most do not. If you prepaid tuition payments are not guaranteed, you may lose some or all of your money in the plan if the plan’s sponsor has a financial shortfall. In addition, if a beneficiary does not attend a participating college or university, the prepaid tuition plan may pay less than if the beneficiary attend a participating college or university.

Educational Savings Plans: Education savings plans let a saver open an investment account to save for the beneficiary’s future qualified higher education expenses – tuition, mandatory fees, and room & board. Due to the new tax codes in 2018, these types of plans can also be used to pay for elementary or secondary schools. Withdrawals from education savings plan accounts can generally be used at any college, university, or secondary school, including sometimes at non-U.S. facilities.

One of the major benefits to education savings plans that it gives the account holder the ability to choose among a range of investment portfolio; from mutual funds, exchange-traded funds (ETFs) to age-based or target-date portfolios. This gives them the ability to determine the risk that they would like to take in the investment of the assets for the beneficiary.

Conclusion

All of the tax-deferred, tax-deductible, and tax-free investment accounts that we have discussed are just a few of the ways investors can begin to plan for retirement. Not all of these will be beneficial to you and your family or accessible to you and your family.

Reach out to Chicago Partners Wealth Advisors to identify your options and determine the best course of action to make sure that you and your family are optimizing all aspects of your most important business, the management of your wealth.

Nicholas Guido, CFP® is a Senior Advisor at Chicago Partners Wealth Advisors. He leverages his 7 years of financial experience to help clients build comprehensive financial plans & investment portfolios.


1Zweig, Jason, Value Should Do Better. But When Is Anybody’s Guess, Wall Street Journal, April 27, 2018.

2JPM Guide the Markets, U.S., 2Q 2018, as of March 31, 2018, p 9.

Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.

November 20, 2018

Prioritizing your Asset to Maximize your Tax-preferred Savings

With all of the tax-deferred, tax-deductible, and tax-free investment accounts that are available to investors how does one know which ones are best for them or even how to prioritize your savings. In this article we will address the primary investment accounts, there benefits, and then how to create the best saving plan strategy for you and your family.

We will start by first outlining the different types of investment accounts, how they work, and their benefits to you.

Single Member Pension – Personal Defined Benefit Plan

A Defined Benefit Plan helps you the self-employed and small business owner save aggressively for retirement by allowing you to make very high contributions. With this type of plan you can target a desired level of retirement income, and contribution amounts are adjusted each year to help you reach your targeted income level. When making contribution to a Personal Defined Benefit Plan the contributions are 100% tax-deductible, within IRS limits, and earnings grow tax-deferred until they are withdrawn.

Benefits:
Substantial benefits can be provided and accrued within a short time period – even when you retire early.

Self-employed individuals or small business owners can contribute, and deduct, more than under other retirement plans.

Vesting can follow a variety of schedules from immediate to spread out over seven years.

In general, the annual benefit for a self-employed individual or small business owner under a defined benefit plan cannot exceed the lesser of: 100% of the self-employed individual or small business owners average compensation for his or hers highest 3 consecutive calendar years, or $220,000 for 2018.

Potential Hurdles

  • Higher cost plan and can be administratively complex.
  • An excise tax applies if the minimum contribution requirement is not satisfied.
  • An excise tax applies if excess contributions are made to the plan.
  • Must file a form 5500 annually.

Contributions

Contributions to a defined benefit plan are based on what is needed to provide a definitely determinable benefit to the self-employed individual or small business owner. Actuarial assumptions are required to determine the contribution levels.

Health Savings Account (HSA)

A health savings account (HAS) is a tax-deductible savings account that is used in conjunction with an HSA-qualified high-deductible health insurance plan (HDHP). HSA regulations allow you to reduce federal income tax by depositing pre-tax money into a health savings account, as long as you are covered by an HSA-qualified HDHP. In 2018, you can deposit up to $3,450 if you have HDHP coverage for just yourself, or $6,900 if you have HDHP coverage for your family. If the account holder is 55 or older they will be allowed to make an additional deposit of $1,000 each year. An HDHP (High Deductible Health Plan) per IRS definition, is a high deductible health plan with a deductible of at least $1,350 for an individual or $2,700 for a family. An HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) cannot be more than $6,650 for an individual or $13,300 for a family.

In addition, to optimize your HSA account, during the contribution periods it is most favorable to cover medical expense from income or outside assets. This will allow your contributions to continue to compound on a tax-deferred basis for a longer period of time.

The Triple-Tax Advantage

  • HSA contributions are pre-tax regardless of your income.
  • No tax on investment gains or interest while the money is in your HSA.
  • Withdraw from your HSA and it is still tax-free; if you use the funds to pay for qualified medical expenses.

Roth IRA

A Roth IRA is an individual retirement account that offers the opportunity for tax-free income in retirement. Both earnings on the account and withdrawals after 59 ½ are tax-free. Annual contributions are taxed upfront and all earnings are federal tax-free when they are distributed according to IRS rules. This is very different from a Traditional IRA, which taxes withdrawals. Contributions can be withdrawn any time you wish and there are no required minimum distributions after age 70 ½ . If you are in a lower tax bracket today than you will be during retirement, a Roth IRA may be a smart choice since you would be paying fewer taxes in the long run. A Roth IRA is also one of the more power savings vehicles available because they do not have required minimum distributions and can pass down to the next generation and withdrawals are still tax-free to the heirs.

Who can contribute to a Roth IRA?

Roth IRA contributions are limited by income levels so you’ll need to check if you’re eligible first. In general, you can contribute to a Roth IRA if you have taxable income and your modified adjusted gross income is either:

  • Less than $189,000 (phasing out at $199,000) for married couples filing jointly
  • Less than $120,000 (phasing out at $135,000) for individuals
  • Less than $100,000 for married couple filing separately

Backdoor Roth IRA Contribution

What is a Backdoor Roth IRA Contribution?

A backdoor Roth IRA allows you to get around income limits by converting a Traditional IRA contribution into a Roth IRA.

Contributing directly to a Roth IRA is restricted if your income is beyond certain limits, but there are no income limits for conversions.

The amount of money you can contribute to a Roth IRA is normally limited, but a backdoor Roth IRA has no limits on the amount of the conversion.

This strategy allows individual to take advantage of the tax-free withdrawals of the Roth IRA even when their income excludes them from making direct Roth IRA contributions.

Are there any restrictions or obstacles to the Backdoor Roth IRA Contribution?

Yes, there is the IRA Aggregation Rule under IRC Section 408(d)(2). This rule stipulates that when an individual has multiple IRA accounts, they will be required to treat them all as one account when determining the tax consequences of any distributions. This includes a distribution for a Roth conversion.

Traditional & Roth 401(K) Plans

A 401(K) plan is a qualified employer-sponsored retirement plan that eligible employees make salary-deferral contributions to on a pre-tax or post-tax basis. Employers offering a 401(K) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings will accrue in the 401(K) plan on a tax-deferred basis. Also, depending on the type of 401(K) that you have chosen the withdrawals will either be taxable with a Traditional 401(K) or tax-free with a Roth 401(K).

The benefits and characteristics of each of the 401(K) plan types will be similar to that of the applicable IRA accounts, with the exception of the contributions limits and restrictions. The income restrictions that hold true for Traditional and Roth IRA accounts are not there for 401(K) plans.

How much can I contributed to a 401(K) plan?

The maximum contribution to a 401(K) plan, for both types, is $18,500 per year but if you are over age 50 then you are eligible for a $6,000 catch-up contribution.

When you include the employer contribution the total of all sources cannot exceed $55,000 or $61,000 for individuals over age 50. Even though the total of all sources in $55,000 or $61,000 respectively, the employees’ contribution can still not exceed $18,500 or $24,500.

SEP (Simplified Employee Pension) IRA

A SEP IRA is a type of traditional IRA for self-employed individuals or small business owners. Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. Contributions, which are tax-deductible for the business or individual, go into a traditional IRA held in the employee’s name. Employees of the business cannot contribute – the employer does. Like a traditional IRA, the money in a SEP IRA is not taxable until it is withdrawn.

One of the major key advantages of a SEP IRA over a traditional or Roth IRA for a self-employed individual or small business owner is the elevated contribution limit. For 2018 business owners can contribute up to 25% of income or $55,000 per year, whichever is less.

Traditional IRA

A traditional IRA is a type of individual retirement account that allows your earnings to grow on a tax-deferred basis. You pays on your contributions only when you make withdrawals from your account. These earnings will grow tax-deferred until you withdraw them or until you reached 70 ½ and are subjected to Required Minimum Distributions (RMDs). You may contribute up to $5,500 of earned income until age 50, at which time you are given the ability to contribute an additional $1,000 or $6,500 until you reach age 70 ½.

Once you reach the age of 70 ½, you must begin taking an annual Required Minimum Distribution (RMD). These withdrawals are penalty-free and taxed as ordinary income in the year they are withdrawn after the age of 59 ½. If you were to withdraw the funds prior to age 59 ½ the funds would be subjected to ordinary income tax and an additional 10% penalty. A traditional IRA account may be a wise choice if you are going to be in a higher tax bracket now then in retirement. This way, you can benefit the most from the money you put into the IRA if you’re in a lower tax bracket when you retire.

Who Can Contribute?

If you do not have a retirement plan at work and you’re younger than 70 ½, you can contribute to annual contribution limit and deduct the entire amount from your taxes. Also, if you spouse does not work outside of the home, he or she can also invest up to the federal limit and deduct the full amount.

Your contribution will be fully deductible even if your company has provided you with a 401K, as long as your adjusted gross income (AGI) is less than $99,000 for married couples filing jointly, or $62,000 for an individual.

If you have a retirement plan through the workplace the deductibility of the contribution is phased out at $119,000 for married couples filing jointly, or $72,000 for individuals.

If you’re not covered by a workplace plan but your spouse is, your contribution is fully deductible if your combined income is less than $186,000 and gets phased out at $196,000.

529 Plans (College Savings)

A 529 Plan is a tax-advantaged savings plan that was designed to help and encourage family’s savings for their child’s future educational costs. 529 plans are also known as “qualified tuition plans,” are sponsored by states, state agencies, and/or educational institutions and are authorized by Section 529 of the IRC.

There are two types of 529 plans: prepaid tuition plans and educational savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor their own prepaid tuition plans.

What are the Differences between Prepaid Tuition Plans and Educational Savings Plans?

Prepaid Tuition Plans: Prepaid tuition plans let a saver or account holder purchase units or credits at participating colleges or universities for future tuition and mandatory fees at current prices for a specific beneficiary. These plans usually cannot be used to pay for future room and board at colleges and universities and do not allow you to prepay for tuition for elementary or secondary schools.

Prepaid tuition plans are not guaranteed by the federal government. Some state governments guarantee the money paid into the prepaid tuition plans that they sponsor, but most do not. If you prepaid tuition payments are not guaranteed, you may lose some or all of your money in the plan if the plan’s sponsor has a financial shortfall. In addition, if a beneficiary does not attend a participating college or university, the prepaid tuition plan may pay less than if the beneficiary attend a participating college or university.

Educational Savings Plans: Education savings plans let a saver open an investment account to save for the beneficiary’s future qualified higher education expenses – tuition, mandatory fees, and room & board. Due to the new tax codes in 2018, these types of plans can also be used to pay for elementary or secondary schools. Withdrawals from education savings plan accounts can generally be used at any college, university, or secondary school, including sometimes at non-U.S. facilities.

One of the major benefits to education savings plans that it gives the account holder the ability to choose among a range of investment portfolio; from mutual funds, exchange-traded funds (ETFs) to age-based or target-date portfolios. This gives them the ability to determine the risk that they would like to take in the investment of the assets for the beneficiary.

Conclusion

All of the tax-deferred, tax-deductible, and tax-free investment accounts that we have discussed are just a few of the ways investors can begin to plan for retirement. Not all of these will be beneficial to you and your family or accessible to you and your family.

Reach out to Chicago Partners Wealth Advisors to identify your options and determine the best course of action to make sure that you and your family are optimizing all aspects of your most important business, the management of your wealth.

Nicholas Guido, CFP® is a Senior Advisor at Chicago Partners Wealth Advisors. He leverages his 7 years of financial experience to help clients build comprehensive financial plans & investment portfolios.


Important Disclosure Information

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.