By Brittany N. Cox, Associate Advisor at Nestlerode & Loy, Inc.
In light of all of the recent conversation in the news about tax changes, I thought it may be beneficial to talk about some of the options for retirement planning and what the effects of different forms of retirement contributions have on your taxes. According to a study by Bankers Life Center for a Secure Retirement, Americans tend to know more about what the taxes would be for the unlikely chance of hitting the lottery than they know about what the taxes will be on their own IRAs, 401(k)s and Social Security.
The most common way of saving for retirement is through a workplace plan such as a 401(k). About $19 of every $100 in U.S. retirement assets is in a 401(k) according to cnbc.com. The 401(k) allows employees to set aside some of their paycheck for retirement while avoiding paying any taxes on those dollars until they make withdrawals in retirement. Retired individuals tend to have less income and therefore fall into a lower tax bracket, ultimately lowering the tax burden for the individual.
To put that into perspective, let’s assume your salary is $35,000 and your tax bracket is 25 percent. When you contribute 6 percent of your salary ($2,100) into a tax-deferred 401(k), your taxable income becomes $32,900. The income tax on $32,900 is $525 less than the tax on your full salary. This year, employees can contribute up to $18,000 to their 401(k) account unless they are aged 50 or over in which case they may contribute up to $24,000. These limits are increasing in 2018 to $18,500 and $24,500, respectively.
The 401(k) is beneficial since it is most common for contributions to be deducted directly from the employees’ paycheck. An increasing number of employers automatically enroll their employees into a 401(k) plan and some even automatically increase their contribution rate annually in hopes of setting their employees up for better retirements.
The 403(b) plan is nearly identical to a 401(k) plan. It is designed for employees of nonprofits such as public schools, hospitals, churches, etc. They are funded primarily by the employee and the contributions are tax deductible when they are made. Employers have the option to match contributions made by employees up to a certain percentage. Earnings in the account grow on a tax-deferred basis, meaning that taxes will be paid on the earnings in the account when the funds are withdrawn during retirement. Contribution limits are the same as those of 401(k) plans.
457 plans are essentially 401(k) plans for state and local government workers. They work the same as 401(k)s and have the same contribution limits. The benefit to 457 plans is that if an employer offers both 457 and 401(k) plans, the employee may contribute the maximum to both plans. This would enable an employee to contribute $18,000 to each plan for a total of $36,000 in 2017.
For those who work for employers that do not provide an employer-sponsored retirement plan, you can still contribute to a retirement account. Individuals can contribute to an IRA with after-tax dollars. Withdrawals in retirement will only be taxed on the earnings. An individual can contribute up to $5,500 in 2017 and those aged 50 and over may contribute $6,500. The contributions made to a Traditional IRA are tax deductible in the year they are made on both state and federal tax returns. Anyone with earned income may contribute to an IRA, but tax deductibility is based on income limits and participation in an employer plan. Note that with Traditional IRAs mandatory withdrawals (RMD) must start when the individual reaches age 70 ½ or a penalty will be assessed.
Another option for those contributing individually is the Roth IRA. The contribution limits are the same as a regular IRA, except that withdrawals from a Roth IRA are completely tax free in retirement. However, there is no deduction for contributions at the time they are made. Eligibility for Roth IRA contributions is based on your adjusted gross income. Another fact to remember about Roth IRAs is that there is no rule on when the funds must be withdrawn.
So, with an IRA you avoid tax when you put the money in and with a Roth, you avoid tax when you take the money out in retirement. You pay no tax on the growth in either, as long as it remains in the account.
These are only some of the most common options available for retirement savings. You should consult with your financial advisor about what options are available to you specifically and which might be the most suitable.
