Contributing to a retirement plan either through a 401(K) or IRA
makes sense for practically all taxpayers. It is one of the easiest and most
powerful ways to reduce your overall tax burden. In fact if these accounts were
more accurately referred to as tax-reducing accounts people would likely take
greater notice of them. Tax avoidance is the primary objective that sparks
taxpayer interest in retirement accounts and retirement planning in general, so
if they were marketed this way it could help generate more interest. First and
foremost you must save for your retirement and you should always make it a
practice to pay and invest part of your paycheck for yourself first because
that is the reason why we all work after all isn’t it? Second, the
contribution you make to a retirement account is not applied towards your
adjusted gross income (AGI), therefore it will keep you in a lower tax bracket
so you’ll end up paying less in taxes. The next benefit comes from having
this money invested in a tax deferred account so you can enjoy the substantial
benefits of tax deferred compounding with the growth which occurs in the
account not being taxable until you retire and begin withdrawing funds.
Presumably at retirement you will be in a lower marginal tax bracket however
even if you are not, you will should still come out ahead because the act of
deferring taxes and the benefit of compounding over many years will likely
leave you with more funds accumulated in a retirement account even if your tax
rate is indeed higher in retirement.
Many employers sponsor retirement plans for their employees and
will also contribute something towards their account as well. This essentially
serves to increase an employee’s total compensation by the employer
without raising the employee’s taxable income level. If your employer does
not offer a retirement savings plan, check to see if you qualify for an IRA on
your own. There are a variety of IRA’s which individuals can contribute to
and you should verify whether you qualify to deduct the contributions you make
from your taxes by reducing your adjusted gross income (AGI). You can
contribute pre-tax money to your employer based retirement plans either through
a 401(k) or 403(b) and if you are self-employed through a SEP-IRA or Keogh.
Far too many taxpayers miss out on the incredible opportunity to
reduce their taxes because they refuse to pay themselves first and instead
spend all of what they’ve earned. Unfortunately in doing so not only do
you end up with less saved for retirement but you also end up paying higher
taxes, both equally negative consequences. In fact delaying the act of
retirement savings can cost you exponentially each decade you wait. Every
decade you delay in making contributions almost doubles the percentage of your
earnings you will then have to set aside in order to meet your needs at
retirement. For instance if you begin consistently saving 5% in your twenties
that means you won’t have to set aside 10% in your thirties, 20% in your
forties and 40% (ouch) in your fifties. Note that catch up provisions now exist
for those getting a late start and typically apply to those taxpayers age 50+.
Recognize that getting a late start in saving for your retirement means
dramatically reducing the amount of discretionary income you will have to spend
and enjoy later in life.
Below are the Standard
Contribution Limits for 2006
Plan Type:
Under Age 50
Age 50+
Employer Sponsored Plans:
$ 15,000.00
$ 20,000.00
(i.e. 401(k) and 403(b))
Popular Small Employer
Plan:
$ 10,000.00
$ 12,500.00
(i.e. Simple IRA)
Regular IRA:
$ 4,000.00
$ 5,000.00
**Roth IRA:
$ 4,000.00
$ 5,000.00
For the Self-Employed:
$ 44,000.00
$ 44,000.00
(i.e. SEP-IRA)
**Roth IRA’s are not pre-tax contributions
they are after tax contributions however you may ultimately withdraw funds from
a Roth IRA upon retirement tax free when reaching the IRS designated retirement
age. Also note qualifying Roth IRA income limits: $150,000 for marrieds and
$95,000 for singles.
Always check with your tax advisor regarding
your own individual circumstances and for verification of current income limits
and qualifications for deducting a retirement account contribution on your
return.
