How Retirement Accounts Save Money on Taxes
Find out how traditional and Roth retirement accounts help you pay less tax and accumulate more wealth for retirement.
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But how do retirement accounts actually help you save money on taxes? This was a common question I recently received at a financial seminar that I presented to a large company in New York City.
In this episode I’ll cut through the confusion and explain terms like "tax-deferred" and "tax-free." You’ll find out how traditional and Roth retirement accounts allow you to pay less tax and accumulate more wealth to spend in retirement.
Plus, I’ll finish by answering a listener question about whether moving to a different state in retirement could affect the tax you have to pay when taking money out of retirement accounts.
See also: How Much Money Do You Need to Retire?
Since taxes take a big bite out of income, it’s smart to cut them every way legally possible. Fortunately, we get a nice tax break for something that we should be doing anyway—saving for retirement.
Retirement accounts can cut your taxes in 2 main ways: tax-deductible contributions and tax-free withdrawals.
How Tax-Deductible Retirement Contributions Save Money
Contributions you make to a traditional retirement account—such as a traditional 401(k) or an IRA—are tax-deductible. In other words, you make them on a pre-tax basis.
Workplace plans deduct contributions directly from your paycheck before taxes are taken out. Or if you make IRA contributions with after-tax money, you get to claim a deduction for those amounts when you file your taxes.
For instance, if you earn $50,000 and contribute $5,000 to a traditional IRA or 401(k), you only have to pay tax on $45,000 that year. Avoiding tax on $5,000 of income could save about $850, depending on your situation and the state where you live.
Reducing the amount of income you have to pay tax on is a smart way to keep more of your money and pay less to the government.
Annual contribution limits for retirement accounts are established each year by the Internal Revenue Service. For 2014, you can contribute up to the following amounts to an IRA or workplace plan:
- IRA (under age 50) - $5,500
- IRA (age 50 or older) - $6,500
- 401(k), 403(b), or 457 plan (under age 50) - $17,500
- 401(k), 403(b), or 457 plan (age 50 or older) - $23,000
Plus, employers can add additional funds, such as matching or discretionary contributions, to your account, which allow you to exceed these annual limits.
However, with a traditional retirement account, the tax man catches up to you eventually. Any amount you withdraw is subject to ordinary income tax, plus a 10% early withdrawal penalty if you’re younger than age 59½.
Distributions are added to your total income for the year. You must pay ordinary tax—but not capital gains—based on your income tax bracket at the time you withdraw traditional funds, no matter if the money comes from your original contributions or their earnings.
Traditional retirement accounts are known as tax-deferred accounts because you delay all taxation until you take distributions in the future.