How to Use Retirement Savings for a Tax Deduction
Saving money for retirement is important for your future, but it may also help put more money in your pocket right now. You may be able to use your retirement savings to decrease the amount of taxes that you have to pay, but there are some important rules that you need to know.
Contributions to a company retirement account
If you have a retirement account through work, it is most likely a 401(k). However, other plans include 401(a), 403(b), 457, SIMPLE, or SEP. For all of these types of plans, you can contribute money from your paycheck pre-tax. This means that the money you put into your retirement account is taken out before taxes, which lowers your taxable income. It is an immediate tax deduction. This deduction is reflected on your W2 by lowering the amount of income reported.
You may also have the ability to make Roth contributions to your company retirement account. Roth means that the money that you put in the account will be after taxes have already been paid. This means that you won’t get a deduction in the current year. The advantage of Roth is that the money earned on your Roth contributions is tax-free in retirement.
Any employer contributions to your retirement plan are pre-tax. This means that you don’t pay taxes on the money the company gives you now, but in retirement it will be taxed.
Putting your money into your retirement plan can be a great way to lower your taxes this year, but there are some limits to know about. The maximum amount you can put into most retirement plans as an employee is $19,500 for 2021. If you are over 50, you can add the catch-up provision of $6,500. For SIMPLE plans, the maximum is $13,500 with a catch-up of $3,000.
If you are self-employed and you can put away more money on top of your employee contribution, then the max is $58,000.This can be a great way to defer income and lower your taxes.
What about individual retirement accounts (IRAs)?
If you are not covered by a retirement plan at work, then you can deduct your contributions to a traditional IRA. The maximum contribution limit for a traditional IRA this year is $6,000 plus a $1,000 catch-up if you are over 50.
However, if you or your spouse is covered by a retirement plan at work, your ability to deduct your contributions is reduced.
For Roth IRAs, you can’t deduct your contributions. You can still contribute to a Roth IRA if you have a company retirement plan however, if your income is over a certain limit, you can no longer contribute to a Roth IRA.
Reporting IRA contributions
The company that holds your IRA will give you a Form 5498 each year that shows your IRA balance at the end of the year and the contributions you have made.
Remember, you can still make contributions to your IRA until April 15th, so your form 5498 may not be accurate. You need to keep your own records of your IRA contributions and make sure that you included them when you file your taxes.