Saving for retirement is a life-long activity. Saving as much as you can over time pays off, because it lowers the amount of tax you pay each year and allows you to accumulate more assets for your future retirement.
There are a variety of tax-sheltered plans that will accumulate retirement savings. Each plan has its own unique set of rules for determining what is considered taxable income in retirement. Here is a list of the basic retirement plans that every taxpayer should understand.
Individual Retirement Accounts
Any taxpayer with earned income (from wages or self-employment) can fund an IRA (individual retirement account). Your IRA contributions may be tax-deductible. There are traditional (deductible) IRAs, Roth IRAs, and non-deductible IRAs. Which one is best for you depends on your income, whether you are covered by a group retirement plan at work, and whether you prefer a tax deduction now or tax-free income in retirement.
Deductible Traditional IRAs
In 2021, you could save up to $19,500 in your 401(k); this increased to $20,500 for 2022. The limit for individual retirement accounts (IRAs) is currently $6,000.
For tax years 2020 and later, there is no age limit on making regular contributions to traditional or Roth IRAs. Older savers' (age 50 or older) contribution limits consist of a "base" contribution limit and a "catch-up" contribution limit. For example, in 2021 and 2022, the base contribution limit is $6,000. For IRAs, you can put in an additional $1,000. Therefore, a person who is 52 years old, and otherwise qualified for a Traditional IRA, could contribute $7,000 total to his or her account. Contributions to a traditional IRA are tax-deferred, meaning that you will not pay income tax until you withdraw the money.
You can begin making withdrawals from your traditional IRA at the age of 59 1/2 without having to pay the early-withdrawal penalty. All withdrawals are taxed, including past contributed principal, since it was tax-deductible at the time the contribution was made, by the age of 72 years old so you cannot accumulate too much money in the tax shelter.
If your income exceeds specific levels, you may not be able to make tax-deductible contributions to your regular IRA, or the amount of your contribution may be limited due to certain restrictions. However, you still can save for your retirement with a non-deductible IRA contribution.
Although your non-deductible IRA contributions won't reduce your taxes in the year you make them; you can tax-defer the earnings on them. This is the key tax advantage of a regular IRA. Although you will not receive any immediate tax benefit from a non-deductible IRA contribution, the tax-deferred growth may ultimately make the contribution worthwhile, especially if you expect to have a lower tax rate after you retire than you do now.
Contributions to a Roth IRA are made with after-tax dollars and are not tax deductible at the time they are made. However, unlike a traditional IRA and subject to certain minimal conditions, if you need to make a withdrawal of your past principal contributions, you can do so tax-free without an early withdrawal penalty, though you won't be able to replace the funds once they've left the account. There are tax consequences for any investment gains or other funds in excess of the historical contributions into the Roth IRA if taken before the age of 59 1/2 years old.
During the years the money is in the Roth IRA, any profits you generate will grow tax-free, and there is no mandatory distribution age. Bankruptcy protections cover the traditional IRAs and Roth IRAs.
If you have income exceeding the limits for a regular IRA deduction, a Roth IRA might be preferable to a non-deductible IRA. Although neither contribution is deductible, with a regular IRA the contribution grows tax-deferred, but a Roth IRA contribution grows tax-free.
401(k) Savings Plans
A 401(k) plan is a workplace retirement account that's offered as an employee benefit. The account allows you to contribute a portion of your pre-tax paycheck to tax-deferred investments. Every dollar you contribute reduces your taxable wages, thereby lowering your taxes. For example, you would be taxed on $70,000 if you earned $75,000 and contributed $5,000 to your 401(k).
Investment gains grow tax-deferred until you withdraw the money in retirement. If you withdraw funds from the plan before age 59 1/2, however, you could pay a 10% penalty, and the withdrawal would be subject to federal and state income taxes.
Many employers match employee contributions to a 401(k), typically up to 6%, although it might "vest" its contributions over a period of years. This means you would not be able to take your employer's contributions with you if you were to leave the company before the prescribed period of time has elapsed. Your own contributions to the plan are always yours, however.
An employer match is effectively free money. Employers who offer these plans are often willing to let you make contributions through automatic payroll deductions, making saving easier.
Investment choices for these types of plans are often limited, and management and administrative fees can be high. The IRS imposes contribution limits per year, although limits for 401(k) plans are more generous than those for other plans: $19,500 in 2021 and $20,500 for 2022. They increase to $26,000 in 2021 ($27,000 in 2022) if you're age 50 or older.