Picture this: you have spent your whole life earning and saving. You’ve worked hard toward a well-earned retirement. You’ve made it to the mountain top, now it’s time to enjoy the view. But suddenly, tax season rears its head and you’ve come to find out that you were too good at making money. And that’s not a compliment where the government gives you a special plaque for your financial literacy. Instead, they reward you in the form of steep taxes and sometimes penalties, too. You quickly come to the realization that you don’t have near as much monthly income as you thought you would, and you might have to tweak your expectations for what’s possible in your next chapter of life. A dark reality, but luckily, a very avoidable one. Tax season does not have to be a point of stress whenever it rears its head. There’s a number of opportunities you can start utilizing today to both reduce your tax liabilities, and even put more money in your pocket! Let’s break them down, shall we?
Contributing to a 401k plan
If your company offers you a 401k plan, it’s wise to optimize it to the best of your ability. Why? Because it’s a lot more than your company helping you on your journey to retirement. Contributing to your 401k allows you to defer paying income tax on your retirement savings until the money is withdrawn. As of 2024 tax code, workers can defer taxes up to $23,000 of what you deposit into your plan, which is a $500 bump from last year’s max. Further, if your contributions are made through a payroll deduction, you’ll get a tax break near immediately because less money will be withheld for income taxes – which means more money to put toward your nest egg. Interestingly enough, there is also such thing as a Roth 401k plan, which functions similarly to a Roth IRA. Just as with your typical Roth IRA, you are taxed on your contributions first so that your money can grow tax-free on withdrawals after age 59 ½.
Contributing to IRAs
Now, if you don’t love the investment options provided by your employer sponsored plan and are still looking for tax advantages, contributing your savings to an IRA is something to consider. “IRA” stands for Individual Retirement Account. There are various kinds of IRAs, but for now we’ll focus on the two most common: Traditional IRAs and Roth IRAs. For both accounts, you can contribute up to $7,000 annually. Like the 401k plans mentioned above, it becomes a matter of if you would like to be “taxed on the seed or the harvest.” For Traditional IRAs, you are taxed once you withdraw your money. But for Roth IRAs, your contributions are taxed, which allows for your money and investment income to grow tax-free. Therefore, when it comes time to withdraw your money, that money is all yours with no serious hit based on your tax bracket. Again, the emphasis on why you’d consider investing into an IRA is not only because of the tax advantages, but also because you have much better flexibility in what you can invest within your IRA. With 401k plans and other employer plans, you may find that they have a set amount of investment vehicles for you to choose from and may also generate your investments for you based on a loose idea of your risk tolerance. Whereas with an IRA, you can invest in a wide range of vehicles, from individual stocks and bonds, to ETFs and Mutual Funds, to real estate. However, life insurance, collectibles, and s corps are exempt.
Making Catch Up Contributions
Some of you may not be familiar with what this is, so I’ll defer to the IRS on this one. According to them, “a catch-up contribution is an elective deferral made by a participant age 50 or older that exceeds a statutory limit, a plan-imposed limit, or the actual deferral percentage (ADP) test limit for highly compensated employees (HCEs).” That catch up contribution is $1,000 this year for IRAs, which means individuals aged 50 and over have an opportunity to defer on taxes up to $8,000. For those aged over 50 with a 401k, you can defer an additional $7,500 on your taxes. This is in place to cut some slack to those who may have fallen behind a little saving for retirement in their younger years.
Avoid Early Withdrawal Penalties
Believe it or not, this one is less than obvious. Something very important to note when you’re committing contributions to a tax-advantaged account or employer sponsored plan, is that it’s wise to ensure you won’t need that money in case of an emergency. As a general rule of thumb, it’s very important to have the right intentions in mind whenever you commit your money somewhere. In this case, IRA withdrawals before age 59 1/2 and 401(k) withdrawals before age 55 could result in the IRS dinging you a 10% tax penalty. Now, there are instances in which the IRS allows you to bypass that penalty based on the kind of purchases you need to make, which you can check out here.
Overall, tax planning continues to be one of the more neglected aspects in retirement planning, all the more reason to meet with a financial professional for a tax analysis. It’s also never too early to start planning ahead!
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We are an independent firm helping individuals create retirement strategies using a variety of insurance products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic retirement income strategies and should not be construed as financial advice.