What if I told you there was a way to avoid paying taxes now, and pay them at a potentially lower rate in the future?
Do you think that would be a great thing?
Congress thought so when they created savings vehicles that have the possibility to do just that. Yes, I am talking about the IRA, 401(k), 403(b).
The idea can be simple.
If you are in a high tax bracket now, 25% and above, can you shift your income to a retirement plan so that when you go to take the money out you will be in a lower tax bracket, thereby avoiding paying more taxes?
Great idea, but how do retirement savings plans work?
We hear the term bounced around so loosely every day around us. People call them 401(k)s retirement, my company plan. There are different types of retirement savings plans. The ones I’m highlighting are a 401(k), 403(b) and Traditional IRA.
So how do you save on taxes? You can save money pre-tax, meaning, if you have money withheld from your paycheck now, you are contributing to your 401(k) without paying taxes on that income. This also means you don’t get to have the money now. Fear not, because your money will grow tax-deferred. As you potentially earn money on your investment it continues to grow at this tax deferred status. The ultimate goal being to end up in retirement with a sizable nest egg, which to live off of.
When you go to break open that nest egg, and start taking money out of it, the money that you take from your 401k, IRA, 403(b) will then be taxed as income, since you have yet to pay taxes on it.
Example: John has contributed $10,000 to his 401(k) over his working career, having his employer withhold it from his paycheck, when he was in the 25% bracket. Now, at age 65 he goes to take money out of the 401(k). He wants to take out the entire amount, $10,000. John is taxed on the money taken out. John is in the 10% bracket so he would owe $1,000 in Federal taxes for the $10,000 withdrawal.
If John had not made a $10,000 contribution to his 401(k) he would instead owe $2,500. This is because he took the $10,000 as income at his tax bracket of 25%! He saved $1,500 on taxes by saving in his 401(k)!
Simple Tip: The higher the tax bracket you are in now, leads to potentially better tax savings now and in retirement by saving into a retirement plan.
Expert Tip: What is the difference between Traditional IRA vs. ROTH IRA? When contributing to a ROTH IRA you pay taxes now, so when you put money into a ROTH IRA, it comes out in retirement tax free, after growing tax free!
Just remember no retirement savings plan is created equal. Even though the term 401(k) is thrown around loosely, it doesn’t mean you have to be the one using the term incorrectly.
A 401(k) and a 403(b) have different contribution limits and rules than a Traditional IRA.
For 2015, you can contribute up to $18,000 into a 401(k) and 403(b) vs. $5,500 for a Traditional IRA. Plus, if you are over 50.5 you can save an additional $6,000 into your 401(k) and $1,000 into your IRA.
Using these types of accounts does come with a drawback, or what I call a safety net for us.
- If you try and take out your money from these accounts before 59.5 you are assessed a 10% penalty on the amount taken. If in the above example John was 58, he would owe 10% of Federal taxes and an additional 10% penalty on the amount he withdrew early. This type of money is meant for retirement so like a good safety net this rule prevents you from falling into the trap of taking your money out when it isn’t intended to be.
*There are special circumstances that allow a penalty free withdraw.
- The traditional IRA has contribution limits. If you make more than $71,000 as a single individual you lose the deduction or pre-tax benefit for that year. The income level is higher for married couples and is around $193,000 before your spouse is completely unable to get the tax deduction.
- Investing the money. Why not take advantage of the tax deferred advantage by investing the money? But how do you invest it? The catch is you most likely will be on your own unless you find someone to help you. Although, there are tools to help assist you in your decision on the type of investments to make, most advice will be general and not specific to your timeframe, goals and needs. Work with a financial advisor to determine the right investments for your situation.
Deferring taxes can be a great thing. With the potential of savings thousands if not more why wouldn’t you be contributing to a 401(k) or Traditional IRA?
Still confused on how to avoid taxes now? Why not schedule a free 30 minute strategy session with me and we’ll talk about how I can help.