Building Your Nest Through Retirement Contributions and Savings
Saving for retirement isn’t easy. Thankfully, the US government recognizes that retirement savings should be incentivized, and there are many ways that you can plan your yearly income to maximize your retirement savings while minimizing your tax liability. Some of the available options offer immediate savings in the form of lowered tax liability in the year of the contribution, while others offer deferred savings in the form of tax-free investment growth.
The more you contribute to your 401(k), the more you will lower your taxable income in the year of contribution. 401(k) withholdings are pre-tax, so this money goes directly to your retirement savings without first being reduced by taxes. This also means that the higher your tax bracket, the more you will save in taxes by increasing your 401(k) withholding. For 2022, employees are able to contribute up to 20,500 to a 401(k). If you are in the 24% tax bracket, making the maximum contribution to your 401(k) could save you up to $4,920, but if you are in the 35% tax bracket, the possible savings jumps to $7,175.
IRA contributions outside your 401(k) can further reduce your overall tax liability. Traditional IRAs are also funded with pre-tax dollars, so this can be a great way to reduce your tax liability or drop to a lower bracket if you anticipate an otherwise high tax year. You can contribute up to $6,000 to an IRA in a tax year. The IRA contribution deadline is exceptionally generous; rather than a January to December tax year, you can contribute to the year’s IRA up until the tax filing deadline in April of the next year. This means two things. First, you can squeeze in some extra savings before Tax Day by shifting some extra cash into your IRA. Second, between January and April, you can contribute to two years’ IRAs at once to maximize savings in both years.
While a Roth IRA isn’t going to give you the immediate tax break that a 401(k) or a traditional IRA will, it can offer a nice tax break years down the road. A Roth IRA is funded with after-tax dollars, meaning that contributing to one won’t reduce your taxable income this year. However, since you paid tax on that money going into your Roth account, you won’t pay tax on it when you withdraw it later. High earners will not be able to take advantage of this, as the full amount of Roth IRA contributions are limited to those who earn less than $129,000 as individuals and $204,000 for a married couple in 2022.This can be a good option if you are in a low tax bracket now, but expect to have higher taxable income in the future.
Many Americans are eligible for a tax deduction on contributions to both a work 401(k) and their individual retirement accounts. Workers who make less than $76,000 for individuals or $125,000 for married filing jointly cannot claim a tax deduction for contributions to both in the same year, but if you or your family earn less than that, you can receive a deduction for contributions to both accounts. Doing this would allow you to deduct up to $20,500 (2022 figures) for your 401(k) and $6,000 for the IRA in the same year.
For married filing jointly households with only one working person, the non-working spouse can also have an IRA with tax-deductible contributions. This allows the working spouse to minimize their taxable income while providing extra money for retirement to the non-working spouse. At $6,000 per IRA, this can reduce a household’s taxable income by $12,000 a year, or $14,000 if both spouses are over 50.
Many people are not privileged to start saving for retirement early in life. If you are over 50 and still making contributions to a retirement account, you have a higher yearly contribution limit for your retirement accounts, and a correspondingly higher allowable tax deduction. Taxpayers over 50 can contribute an extra $1,000 to their IRA accounts, for a total yearly contribution of $7,000. They can also contribute an extra $6,500 to their 401(k) accounts to boost their yearly contributions from $20,500 to $27,000.
This tax planning technique may save you on taxes in the future if you have a year with unusually low taxable income. It is possible to convert a traditional IRA to a Roth if you pay income tax on the account balance in the year of the conversion. Consult with a tax planner if you think this might be a good tax tactic for you this year.
Low-income Americans are rewarded for prioritizing saving for retirement. Taxpayers who earn less than $34,000 for individuals, $51,000 for head of household, or $68,000 for married filing jointly are eligible for the saver’s credit. This credit allows you to deduct the lesser of up to 50%, or $1000 of your retirement tax savings. Above the income threshold, the credit begins to phase out by incrementally reducing the deduction percentage down to 10%, and finally phasing out altogether. This is one of the few occasions that the IRS allows “double dipping” – getting a tax break for the contribution itself, and the saver’s credit on top of that.
IRS form 8888 allows you to send part or all of your tax refund directly into an IRA. Since this is post-tax dollars, you can either send it to a Roth IRA, or elect to use the money to reduce your taxable income in the following year. If you get your tax refund early and deposit your tax refund into an IRA between January and April, you will have to specify to which year’s IRA contributions the tax deduction belongs.
This tax break will only be applicable if you are already retired. If you are over 72, you must take a withdrawal from an IRA or 401(k) account every year, and unless it is a Roth, you must pay tax on the withdrawals. However, charitable contributions are still tax-deductible. If you have no need for the money but must take the withdrawal anyway, individuals over the age of 70.5 can donate up to $100,000 tax-free directly from their IRA to a qualified charity. This will both reduce taxable income and satisfy the minimum withdrawal requirement. However, the donation does not have to be very large. Even a donation of $100 is eligible for the tax-free donation.
Questions about your retirement tax planning? Shah CPA is available for initial consultations, expert tax guidance, and a full list of business advisory services. Contact us at firstname.lastname@example.org or call 646-328-1326.