Retirement planning and tax benefits are closely tied. Let’s take a look at popular retirement plans and the tax benefits each offers:
This retirement savings option is top of the list because it’s one retirement plan that provides prior-year tax savings right up until the tax filing deadline — typically April 15. It lets you save money before it’s taxed.
Afterwards, your traditional IRA earnings then grow tax-deferred. Moreover, the amount you can add to a traditional IRA is adjusted for inflation.
The biggest advantage, for some traditional IRA owners, is that not only can you save up for your future retirement, you can also reduce your tax obligations NOW. The contributions you make can be claimed as an above-the-line deduction, depending on your own earnings and whether you and your partner (if you’re married) have workplace retirement plans. The deductible amount of a traditional IRA contribution could be phased out or completely eliminated accordingly.
For your 2020 tax return, the traditional IRA phase-out trigger starts at $65,000 of modified adjusted gross income (MAGI) for single taxpayers or $104,000 for married, jointly filing taxpayers, both with workplace plans.
So what are the disadvantages of a traditional IRA from a tax point of view? It’s tax-deferred. This means that you will owe tax on your contributions and earnings at some point down the road, typically when you withdraw money after retiring. You can delay them, but the IRS isn’t that nice — you are required to withdraw a certain amount after you turn 72.
For a Roth IRA, you contribute pre-taxed money. That means it’s not deductible, but once you retire and withdraw money, you won’t have to pay any tax on it then.
Since you already paid tax on your contributions, you can withdraw money at any point without having to pay any taxes on it. After you’ve had the Roth IRA for at least 5 tax years, you can withdraw both contributions and earnings without inviting tax trouble once you turn 59 and a half.
The maximum annual contribution to a Roth IRA is $6,000 in 2020, along with a $1,000 catch-up contribution if you’re 50 or above. And like a traditional IRA, you have until April 15 to put the money in the Roth IRA and have it count towards the prior tax year.
So what are the disadvantages? One drawback is that your contribution amount could be phased out or even eliminated if you make more than a certain amount; for 2020, the trigger for reducing contributions is a MAGI of $124K or $196K for single or married jointly filing couples respectively.
These retirement plans have mostly replaced old-fashioned defined benefit pension plans. You open one of these plans at your job and have regular paycheck contributions go into it. Your employer may also contribute to this or match a percentage of your contributions.
401(k) money eventually is taxed, just like a traditional IRA.
The amount you can contribute is adjusted for inflation per year. For 2020, the contribution limit was $19,500. Workers above age 50 could contribute an additional $6,500 to this.
2020 is over now, but it’s not too late to open and contribute as much as you can to a 401(k). The contribution limits remain the same as in 2020.
If you haven’t carefully considered putting away any money for your retirement, do so now. The day you retire will get here sooner than you realize. If you’re forced to take retirement earlier than planned due to unforeseen circumstances, like COVID-19 already has for so many, you’ll be sorted then too.
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