Contributing to tax-advantaged retirement plans is one of the most effective financial planning strategies available to U.S. taxpayers: Saving money in a 401(k), IRA, or a Roth IRA account can trim your tax bill, while helping you prepare for the future. Even if you are already contributing to a retirement plan, you should review your retirement savings strategy regularly to ensure that you are making the most of the tax breaks you qualify for.
When you contribute money to a traditional individual retirement account (IRA) or an employer-sponsored defined contribution plan, such as a 401(k) or a 403(b), the adjusted gross income (AGI) figure that is used to calculate your income tax liability is lowered by the amount saved. Depending upon your income and the amount contributed, depositing funds in an IRA or 401(k) can substantially reduce your tax bill. While taxes must be paid on distributions from these accounts, most savers come out ahead because they are in a lower marginal tax bracket in retirement than they are while working. Investment growth within these retirement plans is also tax deferred. Even savers whose marginal tax bracket is not lower in retirement usually benefit by allowing money they would otherwise have paid in taxes to grow over time.
While the advantages of saving in tax advantaged retirement plans are clear, selecting the types of accounts that are best for your circumstances may be less straightforward. If your company offers a 401(k) plan with matching contributions, start by having your employer deduct from your paycheck at least the amount necessary to take advantage of the full match. If the plan allows, consider contributing beyond the matching limit, up to the maximum of $19,500 or $26,000 ($19,500 + $6,500 “catch-up” contribution), for people age 50 and older in 2020. Depending upon your income, you may also have the option of contributing to an IRA in addition to your workplace retirement plan.
Employees without access to a retirement plan at work, either because they are self-employed or because their company does not offer one, have a number of options when choosing a tax-advantaged savings account. If you have earned income, you and your spouse may be eligible to each make pre-tax contributions of up to $6,000 ($7,000 for those over age 50) to an IRA in 2020. There are also a number of tax-advantaged defined contribution plans designed specifically for the self-employed or small business owners, including simplified employee pension (SEP) plans, SIMPLE IRAs, and owner-only 401(k) plans. These plans are relatively easy to set up and administer, and they can help both owners and employees lower their taxes and build their retirement savings.
While Roth IRAs and Roth 401(k)s do not immediately reduce your taxable income, they can be useful tax planning tools over the long term. The contribution limits for Roth IRAs and Roth 401(k)s are the same as for traditional IRAs and 401(k)s, but the contributions to Roth accounts must be funded with after-tax dollars. Investment growth within Roth accounts is tax free, and no taxes are owed on qualifying withdrawals. However, it is important to note that Roth 401(k)s are subject to required minimum distributions (RMDs) starting at age 72, whereas Roth IRAs are exempt from RMDs.
A Roth IRA can be an attractive option for people who earn too much to contribute to a traditional IRA, but whose AGIs are still below the Roth IRA eligibility phase-out ranges of $124,000–$139,000 for single filers and $196,000–$206,000 for married joint filers in 2020. For married couples who file separately in 2020, the Roth IRA eligibility phase-out ranges of $1 and $10,000. Roth IRAs also offer greater flexibility than traditional IRAs and 401(k)s. Unlike retirement plans funded with pre-tax dollars, Roth IRAs do not require savers to begin withdrawing funds after the age of 72, making it easier to pass on a retirement nest egg to the next generation. A Roth IRA may also be a wise choice for people who do not expect to be in a lower marginal tax bracket in retirement, and wish to maximize their retirement income.
The ideal financial plan may involve contributing to a variety of tax-advantaged retirement accounts. Changes in your income or in tax law can affect your eligibility for some plans. Therefore, be sure periodically review your situation with qualified financial and tax professionals to modify your tax and retirement planning strategies, as needed.