I know retirement plans can be confusing, but they are very powerful tools for saving in a tax optimized way.
The Popular Way
Make tax deductible contributions to your 401k, 403b or other retirement plan.
This allows you to delay paying taxes on a portion of your income until later in life. The idea here is to not pay taxes at your tax rate today, while you are working and have higher income. Instead, you pay taxes in retirement when you are not working and have lower income and hopefully a lower tax rate.
Not only do you get to pay taxes at a lower rate, but you get to have your full amount of pay today working for you as investments for years or possibly decades before paying any tax.
The “Overcontribute” Way
Use your company’s retirement plan to “overcontribute” or make non-deductible contributions over and above the annual limit of $19,500 dollars.
You may want to do this only if your company allows those funds to be immediately converted to Roth inside your 401k. This way, the funds themselves and the growth they provide will never be taxed again as long as you follow the withdrawal rules. Basically, using them for retirement.
The Roth Way
You might even want to make all your contributions Roth, depending on your current tax rate and the tax rate you expect to have when you plan to use the funds.
You can do this by designating your initial contributions as Roth, assuming your plan allows. Of course, if you do this, you will not get a tax deduction for those contributions today.
The Deferred Compensation Way
Your employer might also offer a deferred compensation plan. This is a plan where you can place a portion of your pay, bonus or regular paychecks, into an account without paying any tax and invest it for future growth.
There are many IRS limitations on plans like these and companies have a lot of leeway in designing these plans, but they usually end up forcing withdrawals over a 5 or 10 year period after you leave employment.
One primary difference between a deferred compensation plan and a typical qualified plan (like a 401k) is that the payments are an obligation of your employer. This means if your employer falls on hard times, they may not be able to pay you the deferred compensation payout at all.
This is not the case with qualified plans like 401ks and most 403bs which are fully funded and are not an obligation of your employer.
Things to Consider
Remember tax-deferred does not mean you own the whole balance. If you have a million dollars in your 401k and it’s all tax deferred, that means some of it will be taxed away each time you take money out. In other words, some of that million dollars isn’t really yours.
Also, we are talking here about the tax structure of these plans and not about the investment choices. Sometimes your employer plan will have such poor investment choices that it’s better to just pay the tax as you go and invest outside of a retirement plan.
You really have to dig into the specifics to understand the best tax strategy for yourself, but it will be well worth it in the long run.