Cut Your Tax Bill & Save Money: Tax-Deferred Savings Plans
In Tuesday’s blog, I talked about how tax-exempt savings plans, such as health savings accounts, can reduce your taxable income while also enabling you to save money for future expenses. Today I’ll talk about tax-deferred savings plans, which enable you to postpone paying taxes on some income until a future date.
Before talking about these savings plans, a quick math and tax lesson. Let’s say you earn $50,000 a year, you’re single and you claim the standard federal tax deduction of $5,700. The deduction reduces your total income of $50,000 to a taxable income of $44,300. Assuming no other credits or deductions, you’d pay $7,262.50 in federal income tax.
However, if you make payments into a tax-deferred savings plan such as an individual retirement account (also known as an IRA) or a 401(k), those contributions are subtracted from your total income. Suppose, for example, that you made a $5,000 contribution to an IRA. The Internal Revenue Service allows you to deduct that contribution from your total income. In our example, the $5,000 would be subtracted from your $50,000 total income, which would give you adjusted gross income of $45,000. Once the $5,700 standard deduction is also subtracted, your taxable income is now $39,300. You’d pay $6,012.50 in taxes, compared to the $7,262.50 you would have paid if you hadn’t made the IRA contribution. In other words, your $5,000 IRA contribution reduced your taxes by $1,250, and, for all intents and purposes, it only cost you $3,750 to save an additional $5,000.
Types of Tax-Deferred Accounts
There are several types of tax-deferred savings plans, including traditional 401(k) plans and traditional IRAs. With a tax-deferred savings plan, you are not taxed on money that you contribute to a plan today, but you do pay tax on the money when you eventually decide to withdraw it. These plans offer tax advantages if you think you will be in a lower tax bracket upon retirement than you are in today.
(You may have also heard of Roth 401(k) plans and Roth IRAs. In these retirement savings plans, you pay tax on your contributions now, and no tax on your withdrawals in the future. Since this article is looking at ways to save money and reduce taxes now, I’ll save those plans for a future blog post.)
A traditional 401(k) is one of the best-known types of retirement plans. In a 401(k), an employee or self-employed person puts part of his wages into a tax-deferred retirement account, the traditional 401(k) plan. The individual is not taxed on those wages when they are contributed to the 401(k) plan. However, when the individual starts withdraw money (called distributions), he then pays taxes on the distributions. You can start to take distributions when you are 59.5 years old, and must begin taking distributions by April 1 of the year after you retire or April 1 of the year after you turn 70.5, whichever is later.
In 2010, you can contribute up to $16,500 to a 401(k) plan, and your employer may choose to also make a contribution into your account, up to a combined total of $49,000. If you are 50 or older, you can make an additional "catch-up" contribution of $5,500. Self-employed individuals can also open what is known as a Self-Employed 401(k) with these same contribution limits. (If you are what is known as a highly compensated employee, your contribution limit may be less.)
An individual retirement account, also known as an IRA, also offers individuals the ability to make tax-deferred contributions into a retirement savings account. The amount you contribute to an IRA is subtracted from your total income, thus reducing your federal income tax. You pay tax on the money as you withdraw it. Like a 401(k), you can withdraw money penalty-free starting when you are 59.5 years old, and must begin taking distributions by April 1 of the year after you turn 70.5.
Regardless of whether you have a 401(k) or IRA, you cannot contribute more to the account than your taxable income.
There are a couple of differences between a 401(k) and an IRA. A 401(k) is typically set up by your employer, whereas you are responsible for setting up an IRA. (Most banks and brokerage firms can quickly and easily set up an IRA for you.) IRAs also have lower contribution limits than 401(k) plans. In 2010 you can deposit up to $5,000 into your IRA, or $6,000 if you are 50 or older. If you are covered by a retirement plan at work or if you have a high income, you may not be able to deduct your entire contribution on your tax return.
One advantage of an IRA: You can make your contributions for the prior year up until April 15. So if you haven’t yet made a 2009 IRA contribution and you want to reduce your 2009 federal tax bills, you’re not too late.