Retirement accounts are a great way to reduce your taxable income, thereby minimizing your annual income tax bill. With tax season underway, now is the perfect time to evaluate effective strategies that could help reduce your current and future taxes. Although we naturally think about taxes more as the tax-filing deadline approaches (April 18 for 2022), tax planning should be considered a year-round activity, so it’s wise to revisit these topics regularly in the context of your current financial situation.
If you have the means, maximizing your annual contribution to a retirement account will give your savings strategy a healthy boost. But it’s important to understand how the different types of available retirement accounts differ. The most common options include:
Employer-sponsored retirement plans, such as a 401(k) or a 403(b), allow your investments to grow with taxes deferred until you take money out through a withdrawal or distribution. Some employers offer a traditional 401(k) plan and a Roth 401(k); if yours does, you should be aware of the different rules for taxes on contributions and distributions:
- Traditional 401(k) plan contributions are made with pretax dollars, thus reducing your current income and, possibly, your current-year taxes. Choosing this option may make sense if you want to reduce your income in the current year and/or expect to be in a lower tax bracket in retirement. RMDs from the account begin at age 72.
- Roth 401(k) plan contributions are made with after-tax dollars, and the account’s accumulated funds have the potential to be distributed tax free and penalty free in retirement if certain IRS requirements are met. This could make sense if you’re not looking for a current-year tax deduction and anticipate being in a higher tax bracket in retirement. Under circumstances known as triggering events (one example is termination of employment), Roth 401(k) funds could be rolled tax-free into a Roth IRA and eliminate the need to take RMDs from those assets. RMDs begin at age 72 in Roth 401(k) accounts but aren’t required in Roth IRAs.
If you qualify, you may also be able to contribute to an IRA.
- With a traditional IRA, contributions are generally made with pretax dollars, thus reducing your current income and, possibly, your current-year taxes. Eligibility for making tax deductible contributions to an IRA depends on your tax filing status, modified adjusted gross income (MAGI), and whether you’re covered by an employer-sponsored retirement plan. RMDs begin at age 72.
- With a Roth IRA, contributions are made with after-tax dollars, and the account’s accumulated funds have the potential for tax-free and penalty-free distribution in retirement. Eligibility for contributing to a Roth IRA is based on your tax filing status and MAGI. There is no requirement for minimum distributions when you reach a certain age.
- Converting traditional IRA assets to a Roth IRA is another strategy to consider. Generally, this move makes the most sense for those who anticipate being in a higher tax bracket in retirement than they are now. Eliminating the need to take RMDs is a meaningful benefit.
Get Extra Tax Credit!
Lastly, some individuals in certain income ranges may be eligible for a tax credit of up to $1,000 for contributing to their IRA or employer’s retirement plan. The saver’s credit reduces the federal income taxes that qualifying individuals or married couples pay on a dollar-for-dollar basis. Contributions to 401(k)s, 403(b)s, 457 plans, SIMPLE IRAs, SEP IRAs, traditional IRAs, and Roth IRAs are eligible for the saver’s credit.
These are just a few of the most common tax planning strategies. You can work with us to assess your current situation and determine which options could be beneficial to you. Making proactive, tax-smart decisions throughout the year is an essential piece of overall financial and tax planning.