Saving for retirement is a great way to lower your taxes and build a sizable nest egg. Use these tax tips to boost your retirement savings.
Would you walk away from money?
If you’re among the 51 million Americans who participate in a company’s 401(k) plan, you can contribute up to $19,500 in 2020. And if you are 50 or older, you can stash an extra $6,500 in catch-up contributions, for a total of $26,000.
Every dollar you contribute to the plan is not taxed up front. However, that money is still subject to the payroll tax for Social Security and Medicare.
If your combined federal and state income tax rate is 30%, for example,
- You save $300 in taxes for every $1,000 you contribute to your 401(k).
- So, that $1,000 contribution reduces your take-home pay by just $700.
Some employers match contributions you make to your 401(k) plan, up to certain limits.
- If your company is one of them, make sure you contribute at least as much as needed to capture all matching funds. Otherwise, it’s like walking away from free money.
- Any employer match does not count toward the contribution limit cited above.
Similar tax-deferred retirement plans have identical annual contribution limits, such as:
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- 403(b) plans for teachers and employees of nonprofit organizations
- 457 plans for state and local government employees
- The federal government’s Thrift Savings Plan
Your own boss
If you are self-employed, you can stash even more into a tax-deferred retirement account because you contribute as both an employee and an employer.
With a solo 401(k) plan, available only to self-employed business owners with no employees (other than a spouse), you can contribute:
- up to $19,500 (plus another $6,500 if you are 50 or older) to your tax-deferred retirement account as an employee, plus
- 25% of your compensation (if your business is incorporated),
- up to a maximum combined contribution of $63,500 in 2020.
If your business is not incorporated, you can kick in 20% of your self-employment income (which is total business income minus half of your self-employment tax) up to the same limit. And, if you are 50 or older, you are eligible for an additional $6,500 in catch-up contributions for a total of $63,500.
Another retirement savings option is a SEP IRA, which is good for both self-employed people and those who have side jobs in addition to their regular careers.
Assuming you contribute the maximum to your 401(k) at your day job,
- You cannot take advantage of the $19,500 limit again with a solo 401(k).
- You can open a SEP IRA for your small business or sideline business and save up to 20% of your self-employment income (or 25% of your compensation if your business is incorporated) up to $57,000 in 2020.
Although no catch-up contributions are allowed, the SEP IRA offers one advantage over the solo 401(k): you can set one up at the last minute.
- You have until you file your income taxes for the previous year to establish and fund your SEP IRA.
- With a solo 401(k), you must establish your plan by December 31, but you have until the tax filing deadline, including extensions, to fund it.
If you have employees (other than your spouse) that would be eligible for your 401(k) plan, you aren’t eligible for a solo 401(k), but you do have other options. Consider a SIMPLE IRA, which stands for Savings Incentive Match Plan for Employees.
- In 2020, you can save $13,500 of your self-employment income and your business can kick in another 3%.
- People age 50 and older can tack on an extra $3,000 in catch-up contribution for a total SIMPLE contribution of $16,500.
On your own
You can also save for retirement on your own with an Individual Retirement Account (IRA). If you don’t participate in a retirement plan at work, or even if you do and your income falls within eligibility limits, you can make tax deductible contributions of:
- up to $6,000 to a traditional IRA in 2020, plus
- an additional $1,000 in catch-up contributions if you are 50 or older.
If you participate in a workplace-based retirement plan, you can still make tax-deductible contributions to an IRA if you are single and your income is less than $65,000 in 2020.
- If your income is between $65,000 and $75,000 in 2020, you qualify for a partial deduction.
- If you are married filing a joint return, the phase-out limit for deductible IRA contributions begins at $104,000 in 2020 and the write-off disappears once your income tops $124,000.
If you don’t participate in a retirement savings plan at work in 2020, but your spouse does, you can make tax-deductible contributions to an IRA if your adjusted gross income on your joint return is $196,000 or less.
- You can claim a partial deduction if your income is between $196,000 and $206,000.
- You can’t deduct your IRA contribution once your income tops $206,000.
The Roth IRA option
While most retirement savings plans are based on up-front tax breaks, with the understanding that your withdrawals will be fully-taxable in retirement, the Roth IRA offers the opposite approach.
You get no initial tax break, but all future earnings and withdrawals are tax-free as long as
- your account has been open at least five years and
- you are at least age 59½.
Plus, since you contribute after-tax dollars, you are able to withdraw your contributions (but not your earnings) at any time, tax-free and penalty-free.
Roth IRAs are a great option for anyone interested in tax-free retirement income, and are particularly good for young workers who could benefit from decades of tax-free growth. Roth IRAs are also good for anyone who expects to be in a higher tax bracket in retirement.
There are, however, eligibility limits. For single taxpayers in 2020:
- You can contribute up to $6,000 to a Roth IRA, or up to $7,000 if you are 50 or older, only if your income is $124,000 or less.
- You can make a partial contribution to a Roth IRA if your income is between $124,000 and $139,000.
- Once your income tops $139,000, you are not eligible to contribute to a Roth IRA.
For married couples in 2020,
- $6,000 or $7,000 contributions can be made for each spouse, if income is under $196,000.
- The right to make contributions is gradually phased out as income rises between $196,000 and $206,000.
If the idea of tax-free income in retirement appeals to you, and your income is too high to qualify, there’s a backdoor entrance to the Roth IRA. You can convert a traditional IRA to a Roth IRA, regardless of your income. However, you will not receive a tax deduction for these contributions.
- If these nondeductible contributions represent your only IRA money, then you will just owe taxes on the earnings when you convert to a Roth IRA.
- If you have other IRA assets funded with deductible contributions, only a portion of the amount you convert will escape taxes, since all conversions must be done on a pro rata basis based on the total balance in all of your IRAs.
- A more generous rule exists for after-tax contributions to a 401(k). You can roll over all after-tax contributions directly to a Roth IRA tax-free.
Employers are allowed (but not required) to offer a Roth option for their 401(k) plans. Like the Roth IRA, contributions to a Roth 401(k) are made with after-tax dollars and future withdrawals will be tax-free as long as you adhere to the rules.
If your employer offers a Roth option, consider seriously whether you would be better off foregoing the immediate gratification of a tax break today for the delayed gratification of tax-free income in retirement. You can choose to split your contributions between a traditional and a Roth 401(k) as long as your combined contributions do not exceed the annual limits.