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3 Rules for Making a Year-End Retirement Contribution

How to make your year-end retirement contribution work as hard as you do

Your 401K and IRA retirement accounts might be more valuable than you realize. Too often, you hear a financial guru tell you to “max out” your retirement accounts without knowing Why monthly contributions can be so valuable.

By performing a year-end financial checkup (before December 31), you might realize you need to find a few more deductions to lower your tax bill for the year. Hence, the extra 401K and IRA contributions to lower your taxable income.

Before you decide to send a few extra dollars to your retirement plan, there are a few items to consider:

  • Roth contributions won’t reduce your tax bill
  • You can’t withdraw the money penalty-free until your 59 ½ years old (with a few exceptions)
  • You can only contribute so much each year
  • 401k contributions must be initiated by December 31 (April 17 for IRAs)

Year-End Contributions Make Your 401K Even More Valuable

The best retirement option can be your employer 401k for two primary reasons, employer matching contributions and an $18,000 annual contribution limit for 2017 ($18,500 for 2018), plus a $6,000 catch-up contribution if you’re over age 50.

Let’s start with employer matching contributions. At a minimum, contribute enough of your monthly salary to meet the match. Matching contributions are free money that gains interest the same as your employee contributions, even after you switch employers.

If you still have time to at least “max out” your employer match for the year, do it. Even with my 401k plan, the employer contributions account for 1/3 of the total contribution amount. Not including earned interest, just those contributions will fund my retirement for at least one year.

You might not have the discretionary income to afford it yet, but if you contribute up to the $18,000 contribution limit this year with pre-tax dollars, your taxable income drops $18,000. You can save at least $2,200 in federal income tax based which tax bracket you fall in. You’ll have to pay taxes on the value of your withdrawals in retirement, but your entire contribution will grow tax-free each year until then.

rules for year end retirement contributionJust remember that you only have until December 31 to initiate a 401k contribution to qualify for this tax year.

What are you doing New Year’s Eve?

Traditional IRA Contributions Can Be Valuable Too

With a Traditional IRA, you won’t benefit from any matching contributions, but you can still reduce your taxable income with the tax-deferred contributions.

You can only contribute up to $5,500 per year ($6,500 if you’re at least 50 years old), which is why IRA contributions might be your second choice. That’s still $5,500 you won’t pay taxes on until you make a withdrawal.

A year-end IRA contribution can still be beneficial as you have until the federal income tax filing deadline (April 17, 2018, for the 2017 tax year and April 15, 2019, for the 2018 tax year) to contribute. If you’re a procrastinator or simply don’t realize that you need to “pay in” this year, keep this trick up your sleeve since IRA contributions are one of the very few ways you can lower your tax bill after December 31.

Another reason to consider contributing to an IRA instead of a 401K is that IRAs are self-directed, meaning you can invest the money however you want. You can invest in individual stocks, commodities, peer loans, and real estate in addition to the relatively few funds and bonds offered by your 401K plan provider.

Because countless investing options, you might decide to use your extra contribution to fund an IRA if you’ve already met your employer match or simply don’t like your plan’s investment options or fees.

What About Roth Contributions?

If you have a Roth 401K or Roth IRA, your extra contribution can grow tax-free. You won’t save any money on your tax bill this year, but your contribution will grow 100% tax-free.

When you’re not concerned about the immediate tax savings, a Roth contribution can be just as valuable as a traditional, pre-tax contribution.

You have until April to contribute to your Roth IRA. If you owe less in taxes than you anticipate, you can invest the extra money in your Roth, once your tax return has been filed, and count it as a contribution for this year so you can max out your IRA contribution next year as well.

When You Shouldn’t Make an Extra Retirement Contribution

When you have high-interest debt or want instant access to your cash, an extra year-end retirement contribution isn’t a good idea.

Yes, it’s hard to beat the tax savings, but the restrictions might not be too much with your current financial state.

I’ve said this before; it’s crucial to consistently invest when in debt. Extra contribution or not, make sure you meet your employer 401K match and try to put at least 10% of your monthly income into a retirement account so you can save for the future even while you pay for the past. I followed these two steps when I still had my consumer debt and didn’t begin using my extra income for investing until I paid off those balances.

If you have any debt with an interest rate of at least 10%, use your extra money at the end of the year to pay off those balances first. You will save more in interest than you will earn from an average investment that will earn 7.8% each year.

Just imagine how much more the savings can be if you currently pay a 21% credit card interest rate!

While it’s great to maximize your passive income streams and tax-advantaged investing, your money might not be working as hard as it can be in the short-term when you have a debt albatross around your neck.

Another reason why you might not make the extra contribution is when you plan on using that money before you turn 59 ½. Unless you want to pay a 10% early withdrawal fee (plus 20% in taxes), your extra contribution can end up costing you money. When you foresee a large expense like a car purchase, a 20% mortgage down payment, or even having to buy braces for your child, keeping the money in your savings or a non-retirement investment account so you can at least earn some interest is the wiser option.

Unless you have some expensive debt to repay or you need your extra income for something else before you can withdraw your extra contributions penalty-free, making that extra year-end retirement contribution makes perfect sense. The only decision you need to make is which account to put it in: 401K, tax-deferred IRA, or your Roth IRA.

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