How Saving for Retirement Can Lower Your Current Tax Bill
While the tax deadline (April 18, 2022) is swiftly approaching, there is still time to save on your current tax bill. Many are unaware that you can receive tax breaks today by saving for retirement. This may sound like a win-win situation, but before you jump into anything be sure that you assess your retirement strategy, the tax bracket you are in now versus what it will be when you retire, and other factors with your financial advisor to see if it is more beneficial for you to save now or if you will be saving more in retirement.
Here are a few ways how saving for retirement can lower your current tax bill.
1. Contribute to a Traditional IRA
If you’re in a pinch and want to save on your tax bill, consider contributing to a Traditional IRA. The IRA contribution limit is $6,000, or $7,000 if you are over age 50, of earned income. You can make contributions up to the tax-filing deadline, including any eligible extensions.
Contributing to a Traditional IRA to lower your tax bill is beneficial if you believe that you will be in a higher tax bracket when you retire than you are in now. This is because Traditional IRA funds are tax-deferred, meaning that although you do not have to pay taxes now, you will when you take out your funds in retirement. If everything goes as planned and you are in a lower tax bracket when you retire, you will be paying fewer taxes.
Will My Contribution Be Tax-Deductible?
The ability to write off your contribution depends on your current income and participation in an employer-sponsored plan such as a 401(k) or 403(b). If you are not currently a participant in an employer-sponsored plan, contributions to your Traditional IRA can be partially or fully deducted from your income, resulting in a lower tax bill.
If you participate in any qualified employer-sponsored plan, the deductibility of your contributions is determined by your modified adjusted gross income (MAGI) and your tax-filing status. Refer to the chart below if you hold a retirement plan at work to determine your deduction limit.
|Filing Status||MAGI 2021||MAGI 2022||Deduction Limit|
|Single or Head of Household||$66,000 or Less||$68,000 or less||Full Deduction up to Amount of Contribution Limit|
|$66,000 – $76,000||$68,000 – $78,000||Partial Deduction|
|$76,000 or More||$78,000 or More||No Deduction|
|Married Filing Jointly or Qualified Widower||$105,000 or Less||$109,000 or Less||Full Deduction up to Amount of Contribution Limit|
|$105,000 – $125,000||$109,000 – $129,000||Partial Deduction|
|$125,000 or More||$129,000 or More||No Deduction|
|Married Filing Separately||Less than $10,000||Less than $10,000||Partial Deduction|
|$10,000 or More||$10,000 or More||No Deduction|
What happens if I over-contribute to my IRA?
It is possible to accidentally contribute more than you are allowed. An excess IRA contribution occurs if you:
- Contribute more than the limit
- Make a regular IRA contribution to a Traditional IRA at age 70 ½ or older
- Make an improper rollover contribution to an IRA
There is a 6% penalty of the excess contribution for each year until it is resolved. For example, if you contributed $2,000 more than allowed for your income level, you would owe $120 each year until it has been corrected.
To avoid the 6% tax on excess contributions, you are required to withdraw excess contributions from the IRA by the due date of your individual tax return and any income earned on the excess contribution. However, this will cost you the 10% early withdrawal penalty if you are younger than 59 ½ years old, so it is best to avoid excess contributions altogether.
2. If Over Age 50, Make Catch-Up Contributions
After you reach age 50, you are eligible to make catch-up contributions to your retirement accounts. Workers can defer taxes on an additional $6,500 in a 401(k) plan in 2022 for a total contribution of up to $27,000 and can contribute $1,000 more to an IRA for a total of $7,000 contribution. This in turn can lower the amount of taxable income.
3. Consider Opening a Roth Account or Converting to a Roth IRA
If you think your tax bracket will be higher when you retire than it is now, a Roth IRA may be a more beneficial account for you. Although you are required to pay taxes now, when you take a withdrawal after age 59 ½ and the account has been open for at least 5 years, you will not have to pay any taxes on investment gains. You can also take out Roth contributions tax-free at any time.
Another option is to convert your Traditional IRA to a Roth IRA if you pay income tax on the amount converted. This may reduce your lifetime tax bill if you complete the conversion when you are in a lower tax bracket.
4. Contribute to an IRA and 401(k) in the Same Year
Contributing to both an IRA and 401(k) in the same year maximizes your retirement savings. If offered, it usually makes sense to contribute enough to a 401(k) to receive the employer’s match. If you contribute to a 401(k) you can claim a tax deduction for an IRA contribution if you earn less than $78,000/year in 2022.
5. Create a Spousal IRA
As the name indicates, IRAs (Individual Retirement Accounts), are held by one individual. If you are married, each spouse can open their own IRA and claim double the tax deduction. Even if one spouse is not employed, possibly working as a stay-at-home parent, both individuals can still contribute to an IRA as long as one spouse has earned income.
For example, if Jim and Carly are a young married couple and they both contribute the IRA contribution limit of $6,000 each, if eligible they can defer paying up to $12,000 in income tax.
6. Make a Qualified Charitable Distribution
Traditional IRA and 401(k) accountholders over age 72 must take RMDs (Required Minimum Distributions) and pay income tax on each withdrawal. To avoid this income tax, you can make a Qualified Charitable Distribution instead. This donation satisfies the RMD requirement.
The donation limit to an eligible charity without paying income tax on the transaction is $100,000 for an accountholder over age 70 ½. Donating even a small amount can result in a tax break if you can afford to do so. For example, if you are in the 24% tax bracket when you make the qualified charitable distribution, donating $200 to charity will save you $48 in taxes.
7. Claim the Saver’s Credit, If Eligible
The IRS rewards workers who have low to moderate salaries and still save for retirement. If eligible, you may be able to claim both a tax credit and tax deduction for saving in a retirement account.
For 2022, you are eligible for saver’s credit if you earn less than $34,000 as an individual, $51,000 as head of household, or $68,000 as a married couple. The credit is worth between 10% and 50% of retirement account contributions. The saver’s credit can be worth up to $1,000 for single filers and $2,000 for married couples filing jointly.
8. Add Your Tax Refund To Your Retirement Savings Account
Using IRS Form 8888, you can elect to deposit part or all of your tax refund into your IRA. This refund can be used to reduce next year’s tax bill or, if you meet the IRA contribution deadline, your current tax bill. If you contribute between January and April, make sure to specify whether the contribution is to be applied to the previous tax year or the current calendar year.
There are a variety of ways how saving for retirement can lessen your current tax bill including contributing to Traditional IRA or 401(k), claiming a saver’s credit, making a qualified charitable distribution, and more. However, it is best to consider long-term costs before making important financial decisions such as retirement account type, how much to contribute, and more. Consult a financial advisor and IRA Specialist if you have any questions.