Tax Benefits of Retirement Plan Contributions

Tax Benefits of Retirement Plan Contributions

Retirement Plan

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.

Retirement Planning: What to do when you fall a little short.

Nancy Osborne, Nancy Osborne has had experience in the mortgage business for over 20 years and is a founder of both ERATE, where she is currently the COO and Progressive Capital Funding, where she served as President. She has held real estate licenses in several states and has received both the national Certified Mortgage Consultant and Certified Residential Mortgage Specialist designations. Ms. Osborne is also a primary contributing writer and content developer for ERATE.

"I am addicted to Bloomberg TV" says Nancy.

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