Are you reaching the age where you would like to retire? If so, have you managed to save enough money to retire comfortably? Or will you battle to afford the basics once you have retired?
As highlighted by Phillip Stein, building a substantial retirement fund is one of the most critical aspects of your working life. Not only do you have to put a monthly sum into a retirement savings account, but you also have to consider the tax implications of your savings. In summary, it is essential to take advantage of all the tax breaks offered by the federal or state revenue service.
Therefore, the question that begs is what taxes you have to be mindful of to maximize your retirement savings.
By way of answering this question, let’s consider the following points:
- 401(k) tax deference
Investopedia.com describes the 401(k) retirement plan as the “most popular type of employer-sponsored retirement plan in America.”
Many employers add a monthly 401(k) contribution to their employees’ employment packages.
Succinctly stated, it is the most flexible retirement savings plan. And it is a qualified retirement plan, which means it is eligible for tax benefits as per the IRS guidelines. These guidelines are as follows:
Invest a maximum amount annually without paying tax now
You can invest a portion of your annual salary in the 401(k) plan without paying tax on the invested amount. This contribution limit changes every year, and it is $19 500 for 2020, up from $19 000 in 2019.
The caveat here is that the tax on this money is deferred, not exempt. And there is an annual limit on the amount you can invest before paying tax on any additional investments. While it is essential to note that the more you invest in your 401(k), the higher your retirement funds; however, the annual amount saved must be weighed up against the tax paid. It might be better to instead invest in another type of retirement savings plan.
Tax penalty if withdrawn before maturation date
The minimum age that you can withdraw funds from your 401(k) plan without paying a tax penalty is fifty-nine and a half years old. If you withdraw money any earlier, you could pay the taxes due and a substantial tax penalty of at least 10% on the withdrawn amount.
- The Roth 401(k)
There are similarities and differences between the traditional 401(k) and the Roth 401(k). In summary, the Roth 401(k) contribution limits are the same as the conventional 401(k); however, the tax laws’ application is different. You are allowed to contribute after-tax funds, and then you can withdraw the amount tax-free after retirement. The traditional 401(k) is funded with pre-tax dollars.
Contributions to the Roth 401(k) are not tax-deductible, but you don’t pay tax when you withdraw the funds after retirement. In essence, the difference between these two plans is when you pay tax on the annual earnings deposited into each of these two plans.
- Individual Retirement Account (IRA)
An individual retirement account is a retirement savings plan provided by many US financial institutions. It is a savings account that provides tax benefits on retirement savings. In other words, the tax is deferred until retirement. Financial institutions that offer IRAs or custodians of this form of retirement savings include banks, mutual fund companies, brokerage firms, Robo-advisors, and life insurance companies.
There are several limitations on an IRA, including the following aspects:
- An IRA can only be funded by cash or a cash equivalent.
- The IRA cannot be funded by any unearned taxable income or tax-exempt income, apart from military combat pay.
- The total annual allowed tax-deferred contribution to an IRA or combination of IRAs for 2020 is $6 000 unless you have a work-funded 401(k), and you earn between $65 000 and $75 000.
- Catch-up contributions
Employees aged 50 years and older are entitled to an additional tax break if they make known catch-up contributions on their retirement savings plans. If you take advantage of these catch-up contributions, you could save over $1 000 on your annual tax bill.
Once you’ve turn 50, you can increase your 401(k) contributions from $19 500 in 2020 to over $25 000. Therefore, you can add an extra $6 000 tax-free to your retirement savings.
- Saver’s credit
The IRS website defines saver’s credit as “a tax credit for making eligible contributions to your IRA or employer-sponsored retirement plan.”
The United States Federal government wants you to save for your retirement in that you are offered several benefits for contributing to retirement savings plans.
The saver’s credit (or the retirement savings contribution credit) is available for mid- to low-income earners who save for retirement.
While this credit is similar to a tax deduction, it’s better. The tax deduction reduces your annual taxable income, while the tax credit reduces your tax bill “dollar-for-dollar.” In summary, you are eligible for 50%, or 20%, or 10% of the maximum retirement savings contribution amount depending on your adjusted gross income.