Retirement account contributions are tax-deductible under certain conditions. You can also withdraw retirement accounts funds tax-free under certain conditions. There are certain retirement account strategies that you can take to reduce your tax burden.
There are four common “vested interest” retirement accounts. They are a Traditional IRA, a Roth IRA, a 401K account and a Health Savings Account (HSA). With each one, you add funds to the account. The amount usually grows over time and you withdraw money at a future point. The type of account determines whether you can enjoy tax savings now or when you withdraw money in the future.
Is My Retirement Plan Tax Deductible?
Traditional IRA
With a traditional IRA (Individual Retirement Account), you contribute pretax dollars to a retirement account. For 2020, you can deduct contributions up to $7000 if over 50. However, there are limits on the tax deduction. The limit kicks in if you or your spouse (if married) have a retirement plan at work or make above a certain income. Currently, singles with adjusted incomes over $75,000 with an employer retirement plan cannot take the tax deduction. For couples filing jointly, the deduction maximum is $124,000-$206,000 in adjusted income. The amount depends on whether you or your spouse (or both) has the retirement plan. The IRS taxes withdrawals. The advantage to an IRA is that the tax burden comes after retirement when taxable income is typically lower.
Roth IRA
Roth IRA’s have the same contribution limits as traditional IRA’s. However, contributions are not tax deductible. Withdrawals are also not taxable as long as they meet IRS guidelines.
A traditional IRA requires that you take distributions by 70-72 (depending on your current age). With a Roth, you can contribute or withdraw (or not) at any age. If you expect to work past 70 or do not expect a huge reduction in retirement income, Roth’s provide a tax advantage.
401K
A 401K allows you to contribute to a retirement account managed by your employer. Often the employer will match contributions to a certain percentage. Employee vesting is normally required – meaning you have been with the company for a number of years – to claim the matched funds. If you leave before vesting, you may forfeit funds or get a percentage.
Are 401K Contributions Tax Deductible?
Yes and no. You cannot take your contribution as a “hard” tax deduction on your 1040. However, your employer subtracts 401K contributions from your paycheck upfront, reducing taxable income. Since the amount of your contributions are not income, they are not subject to taxes.
Are 401K Withdrawals Taxed?
Yes, 401K withdrawals are income and taxed as such. There are exceptions, consult the IRS for details.
Health Savings Accounts (HSA)
If you have a high deductible health insurance plan, you can contribute to a HSA. Like a 401K, employers subtract contributions from pre-tax dollars, reducing your taxable income. However, there is a major difference between a 401K and a HSA. You pay taxes on 401K withdrawals. You do not pay taxes on HSA withdrawals as long as it is for a qualified medical expense.
How Can I Reduce or Eliminate Taxes in Retirement?
Consider a Roth IRA
If you expect to be in a higher tax bracket in retirement, this could be a good strategy. You can converts a traditional IRA into a Roth via a “Backdoor IRA”. However, you will pay taxes on the money before you move it over. Cody Crawford with Kirkland, Washington’s SPG Advisors recommends Roth IRA’s over traditional IRA’s or 401K’s for the following reasons:
- Tax-free distribution
- Immediate access to funds over 59 ½ with no penalty
- Unlike with traditional IRA’s, there is no required minimum distribution at 70 or 72
- Tax-free inheritance to beneficiaries
According to Crawford, while you are not able to deduct contributions in the “accumulation phase” of retirement, the taxes that you save once you are in the “distribution phase” more than offsets that.
Avoid Early Withdrawals
You will avoid a penalty and taxes by not withdrawing money from an IRA before 59 ½. You can avoid taxes on a 401K if you leave an employer through transferring money directly into a new 401K plan or an IRA, rather than withdrawing the funds. In addition, withdrawals are tax-free if you leave a job after 55.
Smaller Distributions
Starting withdrawals in your sixties and taking smaller withdrawals each year will spread
the tax burden over more years
Avoid Multiple Distributions
Taxing two distributions in the same year can result in a higher tax bill or a higher tax bracket
Give to Charity
IRA withdrawals up to $100,000 are not taxable (if over 70 ½) if given to charity.
Move to a Tax-Friendly State
You can reduce your overall tax burden by moving to a state without a state income tax and/or lower sales and property taxes.
Time the Sale of Stocks and Investments
Since the IRS taxes gains from investments, time the sale when your income is lower. With a loss, sell the stock when your income is higher to reduce your tax burden.
With retirement accounts, you can experience tax advantages now or in the future. Individual financial situations vary and tax rules change frequently. If you have specific questions on tax deferment for retirement accounts, consult a tax professional, financial advisor or the IRS