Easy Ways to Save and Cut Taxes on Your Retirement Money
Most people know that having an employer offer a 401(k) or 403(b) is a good thing, and they happily agree to have some money put into it every week, but they do so without necessarily understanding all of the advantages that these accounts offer. The same is true for many people who dutifully deposit in an IRA every year: they may have heard that it's a good thing to do, but aren't entirely clear of what the benefit is, and just think of it as another type of savings account. The truth is that there are significant advantages to both of these savings vehicles, but they're best realized when you know exactly what they're doing for you and how to best realize their advantages.
Capital Gains and Long-Term Taxes Compared to Short-Term Taxes
When we earn money, the government takes a portion of it in the form of taxes, but the amount that is taxed and the timing of the taxation is based on the type of account where the money is held. Short-term investments such as Certificates of Deposit (CDs) earn money that is then taxed at whatever your marginal tax rate is: if you earn $100 on a deposit and you're at the highest marginal tax rate of 37 percent then $37.00 of the $100 you earned goes to the federal government plus whatever your state takes in taxes. Comparing that to the way that long-term gains are taxed provides all you need to know about the advantages of tax-advantaged planning: the highest amount that the same $100 can be taxed would be taxed as a capital gain is 20%, meaning that you pay $20 and keep the $17.00 that you'd have had to pay in a short-term gain. If you can forego having that $100 in your hands for a longer period of time, you can hold onto your gains instead of giving it to the government.
Tax-deferred Retirement Planning
Having 401(k), 403(b) and IRA accounts are all considered smart approaches to saving for retirement, in large part because all of them allow you to avoid immediately paying taxes on the interest you earn, the gains you make, or on the monies you deposit at the time you deposit it. All of these factors combine to allow for faster growth and for keeping the amount of money in the account higher, thus allowing for greater earnings right up until the time that it is taken out.
The tax-deferred retirement plans known as 401(k) or 403(b) accounts are sponsored by employers and permit employees to save as much as $18,500 each year in before-tax contributions. In an effort to give employees who are over the age of 50 time to bulk up their retirement savings, the law allows them to save even more each year – up to $24,500. If you opt to save for retirement via a traditional IRA, your contribution is limited to $5,500, and the over-50 boost only adds an extra $1000.
The real beauty of these types of retirement savings accounts, when compared to other types of either short or long-term gains accounts, is that when they are eventually taxed, it will be at your future income tax rate rather than at the higher rate it's assumed you're paying when you're earning employment income.
The money deposited in an IRA or 401(k) is supposed to be untouchable until you are 59 ½, and if it is withdrawn before that time, in addition to paying tax on the withdrawal, you are also financially punished with a 10% penalty. This penalty makes clear that the government's intent in making this type of tax-deferred benefit available is to encourage retirement savings, and that those who end up withdrawing money earlier are not going to be able to get away with it without consequences that take you closer to what you'd have been taxed if your savings had been in a different type of account.
Whenever the money is withdrawn is when the growth and savings are both taxed, and by the time you reach the age of 70 ½, you are required to begin taking money out so that the government can begin to collect the taxes that it has foregone for years.
The biggest difference between these types of IRA and 401(k) accounts and the Roth IRA and Roth 401(k) accounts is that when you deposit money into a Roth-type account, your deposit is made with money that has already been taxed, where the non-Roth accounts are deposited by your employer on your behalf, prior to being taxed. In both types of accounts, earnings, left to accumulate, aren't taxed, but in the Roth-type accounts you're able to take money out before you turn 59 ½ without paying taxes or being penalized as long as you don't take out more than you've put in.
In addition to these savings options, there are other investment strategies that you can choose depending on what your goals are. Whether you are looking for short or long-term gains or taxable or tax-deferred withdrawals, working with an investment manager is the best way to achieve your goals. This is especially important if you want to earn short-term gains while minimizing the taxes you pay or if you plan to retire before you turn 59 1/2. Contacting a tax professional will help you ensure that you fully understand the consequences of all of your financial decisions and are well positioned to have adequate savings.
Spencer Wilson writes for TaxBuzz, a tax news and advice website. Reach him at [email protected].
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