Retirement saving is a lifelong ongoing activity. Saving as much as possible over time helps reduce the amount you pay in taxes each year and allows you to accumulate more assets for your future retirement.
Individual Retirement Accounts
Any taxpayer with earned income (from wages or self-employment) can fund an Individual Retirement Account (IRA). Your IRA contributions may be tax-deductible. There are traditional IRAs (tax-deductible), Roth IRAs, and non-deductible IRAs. Which one is best for you depends on your income, whether you are covered by a workplace retirement plan, and whether you prefer a tax deduction now or tax-free income in retirement.
Traditional Tax-Deductible IRAs
In 2021, you can save up to $19,500 in your 401(k) account; this amount increased to $20,500 in 2022. The limit for Individual Retirement Accounts (IRAs) is currently $6,000.
For tax years 2020 and beyond, there is no age limit for regular contributions to traditional IRAs or Roth IRAs. Contribution limits for older savers (aged 50 and older) include a base contribution limit and an additional catch-up contribution limit. For example, in 2021 and 2022, the base contribution limit is $6,000. For IRAs, you can add an additional $1,000. Thus, a 52-year-old individual who meets the other requirements for a traditional IRA can contribute a total of $7,000 to their account. Contributions to a traditional IRA are tax-deferred, meaning you won’t pay income tax until you withdraw the funds.
You can start withdrawing money from your traditional IRA when you reach age 59 and a half without incurring an early withdrawal penalty. All withdrawals are taxed, including the capital contributed in the past, which was tax-deductible at the time the contribution was made, by age 72, so you cannot accumulate much money in a tax shelter.
Non-Deductible IRAs
If your income exceeds certain levels, you may not be able to make tax-deductible contributions to your regular IRA, or your contribution amount may be limited due to certain restrictions. However, you can still save for your retirement with a non-deductible IRA contribution.
Although non-deductible IRA contributions will not reduce your taxes in the year you make them, you can defer earnings on them. This is the main tax advantage of a regular IRA. Even though you won’t get any immediate tax benefit from a non-deductible IRA contribution, the tax-deferred growth may make the contribution worthwhile in the end, especially if you expect to have a lower tax rate in retirement than you do now.
Roth IRAs
Contributions to a Roth IRA are made with after-tax dollars and cannot be deducted from taxes at the time they are made. However, unlike traditional IRAs and subject to certain minimums, if you need to withdraw your original contributions in the past, you can do so without tax and without early withdrawal penalties, although you will not be able to replace the funds once they leave the account. There are tax consequences for any investment gains or other funds exceeding the historical contributions in a Roth IRA if withdrawn before age 59 and a half.
During the years that money is in a Roth IRA, your earnings will grow tax-free, and there is no specific age for required minimum distributions. Both traditional and Roth IRAs are covered by bankruptcy protection.
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If your income exceeds the limits allowable for a traditional IRA deduction, a Roth IRA may be the better option instead of a non-deductible IRA. While neither contribution is deductible, contributions to a traditional IRA grow tax-deferred, while contributions to a Roth IRA grow tax-free.
401(k) Savings Plans
A 401(k) plan is a workplace retirement account offered as a benefit to employees. It allows you to contribute a portion of your salary before taxes into tax-deferred investments. Every dollar you contribute reduces your taxable income, which lowers your taxes. For example, you would be taxed on $70,000 if you earned $75,000 and contributed $5,000 to your 401(k) account.
Investment earnings grow tax-deferred until you withdraw the money in retirement. If you withdraw money from the plan before reaching age 59 and a half, you may incur a 10% penalty, and withdrawals will be subject to federal and state income taxes.
Many employers match employee contributions to 401(k) accounts, usually up to 6%, though they may “freeze” contributions over the years. This means you won’t be able to take the employer’s contributions with you if you decide to leave the company before the specified period ends. However, your own contributions to the plan are always yours.
Employer matching is essentially free money. Employers that offer these plans are often willing to allow you to make contributions via automatic payroll deductions, making saving easier.
Investment options for these types of plans are typically limited, and management and administrative fees can be high. The IRS imposes annual limits on contributions, although the limits for 401(k) plans are more generous than those applied to other plans: $19,500 in 2021 and $20,500 in 2022. It increases to $26,000 in 2021 ($27,000 in 2022) if you are age 50 or older.
Other types of 401(k) plans include the 403(b), which is a similar account offered to teachers and employees of nonprofit organizations, and 457(b) plans that are offered to government employees.
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Sources:
Internal Revenue Service. “Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits.”
Internal Revenue Service. “Retirement Topics – IRA Contribution Limits.”
Internal Revenue Service. “What If I Withdraw Money From My IRA?”
Internal Revenue Service. “Individual Retirement Arrangements (IRAs).”
Internal Revenue Service. “Hardships, Early Withdrawals and Loans.”
Internal Revenue Service “Roth IRAs.”
Internal Revenue Service. “401(k) Plans.”
Source: https://www.thebalancemoney.com/retirement-savings-plans-3193208
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