New Year’s Financial Resolutions To Start Now
Chances are you’re treating the New Year as a new start — an opportunity to develop good habits that will serve you well over the next 12 months and beyond. Typically, these New Year’s intentions will fall into one of two categories: health or financial resolutions.
For those who want 2017 to be a year where your money works for you, this post will explain the tax implications of your newfound financial resolutions — whether you’re opening a savings account or saving for retirement.
This is a simple, straightforward and safe way to start the savings habit. When you open a savings account, there is an interest rate that comes along with it. This percentage is the amount your money will earn per year — essentially an amount you are charging the bank to use your assets. The best interest rate you’re going to find in 2016 hovers around 1%, with most banks offering even lower rates. Here’s the catch: the interest earned is taxable income, meaning you’ll have to include it when you fill out your tax return. So even though you don’t make a ton of added money from your savings, the interest is taxable.
Putting away a chunk of cash from each paycheck for later down the road will prove to be a smart move once you get there. Whether you want to open an IRA (individual retirement account or annuity) or a 401(k), which is available through an employer, you’ll have to consider the tax implications.
Both types of plans have the traditional (tax deferred contributions and earnings growth) variety, as well as the Roth (after-tax contributions, but tax-free earnings growth) type. In a traditional 401(k), part of your salary is directed to an account and not taxed until you withdraw the money. These contributions have the potential to earn money over time. Tax is paid only when you withdraw the money, which ideally begins when you retire. For a traditional IRA, the deferral is accomplished by deducting your contribution from your total income when it comes time to pay taxes. Simply put, you’ll pay less tax now.
Roth plans are different in that your contribution is made with after-tax funds, so you don’t have to pay taxes when you withdraw them. That means no taxes on qualified withdrawals of both the principal amount you contributed or the interest it earned. Roth IRA contributions can be withdrawn tax-free at any time before retirement age. There are specific rules about making fully tax-free withdrawals. Generally, you must be 59½ or older and your first contribution must have been made at least five years prior. The Roth 401(k) rules are similar, but a bit more complicated.
The general rule of thumb on whether to open a traditional or a Roth IRA is predicting your career trajectory. If you see yourself in a higher tax bracket (i.e., earning more money and in a higher tax bracket) come retirement age, then you should go with a Roth. Remember you’ve already paid the taxes on your contribution—and at a lower tax bracket. If you don’t envision earning that much more money after you retire, then a traditional plan might make more sense. If you’re in a higher tax bracket now than you will be later on, then a traditional IRA is certainly the right move. Many investment professionals would recommend diversifying your retirement plan to include both types.
It’s also worth noting that whichever one you choose is not a permanent decision! You can convert a traditional IRA into a Roth IRA at any time.
Don’t let the subtleties of saving deter you from making good on your New Year’s resolution. The fact that you’re buckling down and thinking about your future is an excellent first step. And if you don’t like the way your money is growing by year’s end, you always have 2018 financial resolutions to make it right.
Learn more about the tax benefits of college savings accounts like 529 plans and Coverdell ESAs with the experts at H&R Block.