Note: The IRS increased contribution limits for most retirement savings plans in the 2020 tax year.
For anybody seeking a comfortable retirement, having a retirement plan is a must. According to data from the 2017 Retirement Confidence Survey from the Employee Benefit Research Institute (EBRI), U.S. workers with a retirement plan, such as a work-sponsored 401(k) or personal IRA, are more than twice as likely to feel confident about having enough money for retirement than those workers without a retirement plan. Workers with a retirement account save more than those without a plan, have enough money to meet their expenses during retirement years, and feel less stressed about retirement preparations, according to the EBRI survey.
Among the top reasons retirement savers are doing financially better is that they’re able to stretch out their paychecks through tax breaks. By contributing to qualifying retirement accounts, you can reduce your taxable income and may qualify for tax credits.
If you’re wondering, “Is my retirement plan tax-deductible?,” the answer is “yes.” You can save for retirement using pre-tax dollars or after-tax dollars. When you use pre-tax dollars to fund your retirement account, the IRS allows you to reduce your taxable income by that amount. If you were to make $50,000 per year and you were to contribute $3,000 to your employer-sponsored 401(k) on that same year, then you would only pay taxes on $47,000. Using this example, here is how much less you could owe in income tax as a single filer in 2017:
Total Contribution to 401(k) Plan Total Income Tax Difference from your regular tax payment
$1,000 $7,988.75 -$250
$2,000 $7,738.75 -$500
$5,000 $6,988.75 -$1,250
$10,000 $5,738.75 -$2,500
$18,000 $4,333.75 -$3,905
As of 2024, individuals could contribute up to $23,000 to a 401(k) plan, and those age 50 and over could sock away an extra $7,500 in catch-up contributions. Just by withholding 4% of every paycheck for an entire year, you would pay $500 less in taxes. In this example, contribute $12,051 or more and you would drop one tax bracket (25% to 15%). In 2018, that annual maximum became $18,500!
Some recent news and discussion around a potentially significant lower limit: 401(k) Legislation: Republican Tax Reform Bill for Contribution Limit Decreases in 2018.
Yes, you can contribute to several retirement accounts, but you’re still subject to the IRS contribution limits. For example, if you were to hold two employer-sponsored 401(k) plans from two different employers, you can still only contribute up to $18,000 in total. Split your contributions whatever way it makes more financial sense to you (50/50, 80/20, or 10/90) but at the end of the year, the total can’t be over $18,000 ($24,000 if age 50 and over).
However, there’s one way to get around the $23,000 contribution limit. By saving with a traditional IRA, you can stash away up to $7,000 extra ($8,000 if age 50 and over) in retirement savings as of 2017. While having multiple 401(k) plans is generally a bad idea, funding both a 401(k) and an IRA to maximize your retirement savings (and income tax deductions!) is always a great retirement game plan.
No, you’ll eventually have to pay taxes on your nest egg. Uncle Sam gives you a break now but he’ll want his fair share once you start taking withdrawals during retirement. Still, it’s a pretty good deal since you’re more likely to be in a lower tax bracket then than during your prime working years.
However, try as much as possible not to take any distributions (i.e., withdraw any money) from your 401(k) before age 59 1/2 or you’ll face a 10% early withdrawal penalty from the IRS on top of applicable income taxes.
There is one way to save for specific retirement savings and not ever paying a penny on income taxes on those funds.
Workers enrolled in a High Deductible Health Plan (HDPH) with an annual deductible of at least $1,300 for personal coverage or at least $2,600 for family coverage, not listed as a dependent on another person’s tax return, and not enrolled in Medicare can choose to save with pre-tax dollars for qualifying medical expenses with a Health Savings Account (HSA). Unlike a Flexible Spending Account (FSA), an HSA isn’t subject to the “use it or lose it” rule. This means you could roll over unused funds year after year until retirement and use those funds to cover medical expenses without paying any income taxes.
Through proper use of an HSA, you can take the tax deduction now and avoid the income tax on qualifying medical expenses now or in retirement.
In addition to reducing your taxable income, by contributing to an eligible retirement account you may be able to reduce your actual tax liability. As of 2017, eligible retirement savers could reduce their tax liability by up to $1,000 ($2,000 if filing jointly) through the Retirement Savings Contributions Credit, more commonly known as the Saver’s Credit.
So, which retirement plan offers tax benefits? Examples of retirement plans that offer tax breaks include 401(k), 403(b), 457 plan, Simple IRA, SEP IRA, traditional IRA, and Roth IRA. Depending on your adjusted gross income (up to $30,750 for single filers and heads of household, and up to $61,500 for joint filers), you can claim 50%, 20%, or 10% of the first $2,000 ($4,000 if filing jointly) in contributions to these plans.
Employer contributions to a retirement account provide tax breaks, too.
Any employer contributions to your plan don’t count towards the $23,000 contribution limit so you can still contribute and reduce your taxable income by up to $23,000 ($30,500 if age 50 and over). As of 2024, the total combined employee and employer contribution is the lesser of 100% of an employee’s compensation or $69,000 ($76,500 if age 50 and over).
Employees can defer all applicable income taxes on employer contributions until retirement age when the employees are more likely to be in a lower tax bracket.
Most employers can deduct, subject to limits, contributions they make to a retirement plan, including those made for their own retirement. The contributions (and earnings and gains on them) are generally tax-free until distributed by the plan. This makes employer contributions not only a powerful recruiting tool to attract top talent but also a way to reduce the company’s own tax bill.
In addition, small businesses may be eligible for the Retirement Plans Startup Costs Tax Credit. This tax credit allows eligible employers to claim 50% of their ordinary and necessary startup costs up to $500 per year. Expenses to educate employees about the plan are also eligible. Eligible employers can claim the credit for each of the first three years of the plan and may choose to start claiming the credit in the tax year before the tax year in which the plan becomes effective. As part of the general business credit, a small business owner may carry this tax credit back or forward to other tax years when she can’t use the credit in the current tax year. To claim the credit, use Form 8881, Credit for Small Employer Pension Plan Startup Costs.
For these reasons, contributions to a retirement account are an effective way to increase the take-home portion of your paycheck and decrease the tax liability of your employer.
If you want to set up or switch to a 401(k) that’s great for employees and employers, let your company know about Human Interest.
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.
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