Research says the average age of retirement in the US is 62. But many Americans across different generations say achieving financial security in retirement will be difficult.
That’s why contributing to a retirement fund from an early age is essential. But you shouldn’t just choose any fund for retirement savings. Retirement and taxes actually go hand-in-hand. So you want to choose a retirement account that will lower your tax responsibilities and save you money.
It may sound complicated, but this article will break down everything you need to know about retirement contributions and tax returns.
Will My Retirement Fund Affect My Taxes?
Yes, your retirement fund will affect your taxes. But because there are several different retirement funds you can save in, how much you need to pay in taxes, and when varies.
Each fund has its own rules and regulations regarding paying taxes. This applies to tax obligations now and in the future.
So first, let’s identify the different retirement funds.
Types of Retirement Accounts
You can use several types of accounts to save money for retirement. Some popular options include:
You may also have a pension, which will help fund retirement. Additionally, you can start receiving Social Security benefits between the ages of 62 and 70.
401(k): Employee Matching and Catch-Up
Americans who work at a for-profit company have access to a 401(k) retirement fund. The employer is responsible for setting up the plan, but employees can contribute to it.
In 2022, the annual contribution limit for employees is $20,500. Those aged 50 and above can contribute additional catch-up contributions of up $6,500.
There are no income limits for those who want a 401(k), but your contributions cannot exceed your wages.
Every employer has a different matching problem. For example, some companies match up to a certain amount of percentage. If this is the case, you’ll want to contribute to a 401(k) fund before using other retirement accounts.
This is because your employer is giving you additional retirement savings. It’s like receiving free money!
Usually, with a 401(k), you can invest in mutual funds. A mutual fund is a company that takes money from different investors and invests the money collectively. They may invest the money in:
- Short-term debt
When you own shares of a mutual fund, the combined holdings make up your portfolio.
403(b): Nonprofit Employee and Teacher Retirement
A 403(b) is similar to a 401(k), but it is for employees of public schools and some tax-exempt organizations. This includes religious institutions and hospitals. You may also know a 403(b) by the name of Tax-Sheltered Unity Plan (TSA).
With a 403(b) fund, you can still invest in mutual funds via a custodial account. But you also have the option to make payments over time in exchange for receiving payment benefits later on. This is an annuity contract.
Religious institutions will set up this account for their employees, but it may only function as a savings account without any investment in securities.
Contributions limits in 2022 are the same for a 403(b) as for a 401(k). However, income limits are slightly different. The limit is the wages your employer reported on your W-2. This means you cannot include income from other sources.
Different employers also have various matching programs for 403(b) funds. As with a 401(k), if your employer matches contributions, save money in your 403(b) first before another account.
Further, 457(b) retirement accounts are similar to 403(b) accounts for civil servants, municipal employees, law enforcement officers, and public safety personnel.
Individual Retirement Accounts (IRAs)
An IRA is something you set up on your own, without your employer. You choose the brokerage firm you want the account at. If you wish to contribute to an IRA regularly, you need earned wages or self-employed income.
For 2021 and 2022, the contribution limit to an IRA is $6,000 per year. Those aged 50 and above can contribute additional catch-up contributions of up $1,000. IRAs do have income limits.
But these limits depends on the following:
- Type of IRA
- Filing status
- Your access to workplace retirement plans
- Your spouse’s access to workplace retirement plans
Having an IRA is an excellent choice to have more flexibility in investing. It’s also great to save and build extra wealth before retirement.
But, IRAs do not come with any employee matching since they are individual and separate from your employer. So, if you have a 401(k) or 403(b), max out your contributions to these entirely before contributing funds to an IRA.
SEP IRAs for the Self-Employed
A simplified employee pension (SEP) plan allows the self-employed to fund their retirement. In this case, since the self-employed are the employer and the employee, they can make employer contributions to their plan. It will have higher contribution limits.
In 2022, the contribution limit is the lesser of 25% of the employee’s compensation, or $61,000. A SEP IRA doesn’t have additional catch-up contributions.
It also has an income limit of $290,000. As with other IRAs, there are no matching contributions from an employer.
SEP IRAs are not as popular. They help self-employed with high incomes to contribute more money to retirement accounts.
Small business owners are eligible to use SEP IRAs. But, they must contribute the same percentage to each employee’s compensation. This can get expensive over time.
The government considers pensions to be unearned income. However, if you are eligible for a pension, there’s a good chance it will be taxable.
Income from employer-funded pension plans is taxable at ordinary income tax rates. These are 10-37%, depending on your tax bracket.
Social Security benefits are another form of unearned income. If Social Security is your only source of income during retirement, you probably won’t have to pay taxes on it.
That’s because your income will be too low to meet the tax threshold.
However, if you have any other income, including retirement funds or a pension, you may need to pay taxes on your Social Security income. Up to 85% of your Social Security income is taxable, depending on your total income and filing status.
But, Supplemental Security Income (SSI) is never taxable.
Paying Taxes on Social Security
If you file as an individual with an income of less than $25,000, you won’t owe taxes on your Social Security income. You shouldn’t even need to file a tax return either.
As an individual, if you have an income of $25,000 to $34,000, you need to pay taxes on up to 50% of your Social Security benefits.
If your income is more than $34,000 for an individual, you will have to pay taxes on up to 85% of your benefits.
For married couples filing jointly, you need to pay taxes on up to 50% of your benefits if you have a combined income of $32,000 to $44,000. If you have a combined income of more than $44,000, you need to pay taxes on up to 85% of your benefits.
These are the basic rules for paying taxes on Social Security benefits.
Traditional vs. Roth Accounts
Many of the retirement accounts discussed offer you two choices. They are traditional and Roth.
Usually, traditional retirement accounts give you a tax break when you pay into them. That means you don’t have to pay federal income tax on the contributions.
For example, if you have a traditional IRA, you can contribute $6,000 per year tax-free (federally).
The earnings in a traditional retirement account grow tax-deferred. So, you don’t have to pay taxes on the earnings while you make them.
But, you will need to pay regular income tax on all the money you withdraw from the account.
For instance, if you remove $10,000 from your traditional 401(k) to send your child to college, you will have to pay taxes on it.
Conversely, the Roth option allows you to contribute money without reducing your taxable income. The IRS calls these after-tax contributions. So the same $6,000 you put into a traditional IRA would not be tax-free if it went into a Roth IRA instead.
However, since you pay taxes on the contributed money up-front, if you withdraw after the age of 59 1/2, you won’t have to pay taxes on it.
Additionally, earnings grow tax-free. So, if you wait until 59 1/2 to withdraw any money from a Roth account, you won’t ever have to pay tax on the earnings.
Benefits of a Traditional or Tax-Deferred Account
As mentioned, traditional retirement accounts are tax-deferred, which means you don’t pay tax on the money until you withdraw it from the account.
The advantage of this is that you pay less tax from year to year because you can deduct your contributions from your income.
The idea is that the immediate tax benefit outweighs paying taxes when you eventually make a withdrawal. This is because when you retire, you often have less taxable income. This will put you in a lower income bracket.
High earners should especially max out their tax-deferred accounts to minimize the current tax burden.
Additionally, you can put more money into your retirement account with an immediate tax benefit.
Benefits of a Roth or Tax-Exempt Account
Roth and tax-exempt accounts also have tax benefits, even though they aren’t immediate. The advantage behind these accounts is that your investments grow tax-free.
Let’s look at an example to understand why this is beneficial.
You put $5,000 into a Roth IRA today and invest it in a mutual fund that provides a yearly 3% return. In 30 years, that $5,000 will be worth $12,135.
Essentially, you make $7,135 on that investment, and it’s tax-free.
This concept is in contrast to a regular investment portfolio. That’s because you would need to pay capital gains tax on the $7,135 you made from your investment.
But in a Roth account, when you wait until retirement age, you don’t pay capital gains tax.
Calculate Your Income
To get a general sense of how much you’ll need to pay in taxes, you need to figure out your adjusted gross income (AGI). You should add up all the income from the following:
- Self-employed earnings
- Required minimum distributions (RMDs)
- Qualified retirement accounts
- Social Security benefits
- Any other taxable income
Then you need to add tax-exempt interest. Even though you don’t pay tax on it, the interest still counts toward your total income for the year.
Knowing your AGI will allow you to see which tax bracket you’ll fall into. For 2021, there are seven federal tax brackets. They are: 10%, 22%, 24%, 32%, 35%,and 37%.
How To Reduce Your Tax Bill
Using both traditional and Roth retirement accounts will help you save money.
If you think you will have less income when you retire, using traditional accounts while working will help reduce your tax bill.
This is because you will fall into a lower tax bracket and be responsible for less when you withdraw the money and eventually owe taxes on it.
For example, maybe now you fall into the 24% bracket, but when you retire, you fall into the 22% bracket.
However, consider using Roth accounts if you think you will have more income when you retire because of investments, a pension, and other forms of income.
While you will still pay taxes on your contributions now, you’ll never have to pay taxes on that money, and its capital gains in the future, assuming you wait until you’re 59 1/2 to start making withdrawals.
If you start making withdrawals from a Roth account before retirement, you will have to pay a hefty tax penalty that defeats using the account, to begin with.
Additionally, starting from age 70 1/2, you can contribute money to a qualified charitable distribution (QCD) directly from an IRA account. This will bring further tax savings.
Further, it’s important to remember this guide only discusses federal taxes. State income tax rules vary, and it’s essential to follow up with your state to see how your retirement fund and income will affect your yearly tax filings.
It’s always best to consult with a tax consultant or finance professional to plan for retirement and maximize your tax savings strategically.
Learn More About Your Retirement Fund and Tax Obligations
With this extensive guide, you know about how your retirement fund (or funds) will affect your taxes now and for years to come. But we know this can be a confusing topic to navigate.
So, if you need more help understanding your retirement fund and tax returns, schedule your retirement planning consultation for free with one of our trusted agents.