Like many people, you’ve most likely considered your retirement. Part of any good retirement plan should include tax planning. Often, people turn to a tax-deferred retirement account to minimize their tax bill for this purpose.
Keep reading to learn everything you need to know about tax-deferred retirement plans.
- 1 Understanding Tax-Deferred Retirement Plans
- 2 How a Tax-Deferred Account Works
- 3 Tax-Deferred Savings vs Investments
- 4 Rules for Tax-Deferred Contributions
- 5 The Benefits of Tax-Deferred Retirement Plans
- 6 Accessing Your Savings Before Retirement
- 7 Tax-Deferred Annuity Contribution Limits for 2022
- 8 Tips for Saving More
- 9 Learn More About Managing Your Finances
Understanding Tax-Deferred Retirement Plans
Most people hope to retire around the age of 62. A deferred retirement savings plan is an investment account that can help you meet that goal. It enables you to postpone paying taxes.
The money you save gets deducted from your gross income. You’ll receive an immediate break on your income tax.
You can invest the money you saved until you withdraw it. Usually, people withdraw these funds when they retire.
The most popular tax-deferred retirement plans are 401(k)s and individual retirement accounts (IRAs).
How a Tax-Deferred Account Works
The name of this kind of account makes it relatively easy to understand. As suggested by its name, a tax-deferred account enables you to enjoy an immediate tax deduction.
You’ll receive a tax deduction up to the full amount of your contribution. The IRS will tax future withdrawals from your tax-deferred account at your tax rate during that time. In the United States, most people invest in IRAs and 401(k)s for tax-deferred savings.
An Example of Tax-Deferred Savings
Suppose you earn $50,000 per year. Now, imagine that you’ve contributed $3,000 per year to your tax-deferred account. In that case, you’d only pay taxes on $47,000.
Now, suppose that you retire in 30 years. At that time, you might have $40,000 in taxable income.
However, you decide to withdraw $4,000 from your account. In this case, you will pay taxes on $44,000 for that year.
Tax-Deferred Savings vs Investments
If you’re planning your retirement savings, it may also help to compare tax-deferred savings to a standard taxable investment portfolio. With an investment portfolio, you’d pay capital gains taxes for any profit when you sell your investment.
However, a tax-deferred retirement account works differently. You’d pay standard income tax when you retrieve distributions from your account, whether contributions or earnings.
As you’re planning your retirement, you may want to bear in mind that long-term capital gains tax is lower than regular income tax.
Rules for Tax-Deferred Contributions
In 2020 and 2021, you could’ve contributed as much as $19,500 to a 401(k) savings plan. If you were 50 or older at that time, you could’ve also contributed $6,500 in catch-up contributions.
In 2022, the catch-up contribution amount remains the same. However, you can contribute as much as $20,500 to your 401(k) savings plan.
If you’re 50 older in 2022, you can contribute that amount plus $1,000. However, your contribution amount could change. For example, if you participate in a workplace retirement savings plan, your contributions may reduce what you’re allowed to invest in your traditional IRA account.
Something to Consider
Remember, with a tax-deferred account, you’ll pay taxes in the future. Meanwhile, your investment can grow tax-free.
In this way, a tax-deferred account is really a “tax-delayed” account. Eventually, you must pay taxes on your balance.
Ideally, you should maximize your contribution to a tax-deferred account. If you can’t make the full contribution to a tax-deferred retirement account, consider a different retirement saving strategy.
For many, it can prove challenging to save for retirement. If you don’t earn enough to contribute the full amount to a tax-deferred account, think about investing in a tax-exempt account instead.
Choosing Your Investment Strategy
If you can’t afford the full contribution to a tax-deferred account, it doesn’t make much sense to use one. Your tax savings would prove minimal. However, you could end up facing a significant tax obligation in the future.
Suppose you were to contribute $1,000 into a tax-deferred account. Now, imagine that you pay 12% in income taxes. You’ll save $120.
Now, suppose you’re in a higher tax bracket in five years. For instance, you might pay 32% in income tax at that time.
In that case, you’d pay $320 in taxes. In other words, you’ve effectively paid $200 extra to defer your taxes to a later date. As you can see, this isn’t the most prudent strategy for saving toward retirement.
If you’re in a lower income bracket, you may want to consider a tax-exempt retirement savings account. Suppose you have a higher tax bracket in the future, and you invest in a tax-exempt account.
You’ll pay 12% on the retirement money that you’ve invested. You’ll save yourself from paying 32% in taxes when you withdraw your retirement money.
Who Decides if a Plan Is Tax-Deferred?
The Internal Revenue Service (IRS) qualifies tax-deferred savings plans. The agency allows taxpayers to use these plans to save money. They’ll then deduct the amount the taxpayer has saved from their taxable gross income for the year.
You’ll only have to pay taxes on your contribution and investment returns when you withdraw money. Usually, you wouldn’t withdraw money until you retire.
For instance, contributions to traditional IRAs are tax-deductible. However, you may face some income limitations if you or your spouse has a workplace retirement plan.
Meanwhile, contributions to a Roth IRA are not tax-deductible. Still, if you have money in both a Roth IRA and traditional IRA retirement account, your money will continue to grow tax-free until you make a withdrawal.
Let’s have a look at a few different types of tax-deferred plans.
Tax-Deferred 401k Plans
Many employers offer a 401(k) savings plan for employees. It enables them to build tax-deferred retirement savings.
Meanwhile, public service employees have a similar investment vehicle called a 403 (b) retirement savings plan. Likewise, government employees would enjoy tax-deferred savings with a 457 retirement savings plan.
Sometimes, an employer will sponsor employees’ 401(k) plan. They’ll match a portion of the employee’s contribution.
Typically, employers have a standard limit for matching contributions. On average, employers might match employee contributions by about 3%.
Self-employed individuals and just about anyone who earns taxable income might consider a standard IRA account for retirement savings. You can open a standard IRA account at many banks and brokerages. These institutions offer a wide range of investment options.
As an aside, if you have a 401(k) or traditional IRA, you must take a required minimum distribution (RMD) starting at the retirement age of 72. These distributions are taxable at your current tax rate on withdrawal.
You may also consider a tax-deferred annuity for retirement savings. Sometimes, you may hear someone refer to this kind of investment vehicle as a tax-sheltered annuity.
A tax-deferred annuity is a long-term investment account. Its purpose is to provide you with regular income payments after you retire. You can purchase a tax-deferred annuity from an insurance company—more on tax-deferred annuities in a moment.
Tax-Deferred US Savings Bonds
You may also consider investing in US savings bonds to build your retirement savings. The US government issues two kinds of tax-deferred bonds—Series EE and Series I. As a bonus, these tax-deferred bonds provide an extra benefit if you use them to pay for educational expenses.
A Series EE bond pays interest for the duration of the life of the bond. Typically, this period lasts for 20 years. A Series I bond pays interest for up to 30 years.
The IRS will not tax the interest paid out while you’re holding either type of bond. However, you must pay taxes on interest earned when the bond expires or you redeem it.
The Benefits of Tax-Deferred Retirement Plans
Tax-deferred retirement savings provide an immediate advantage. They enable you to pay fewer taxes for the current tax year. In this way, tax-deferred savings serve as an incentive for people to save toward retirement.
The concept behind tax-deferred savings is that the immediate benefit of contributing to retirement outweighs potential negative tax implications in the future.
When you retire, you’ll most likely generate less taxable income. As a result, you’ll fall into a lower tax bracket.
Financial advisors strongly encourage high earners to contribute the maximum amount to tax-deferred accounts for this reason. This tactic can help them save on their current tax responsibility.
Also, tax-deferred accounts give you an immediate tax advantage. Suppose you’re in the 24% tax bracket you contribute $2,000 into your tax-deferred account. You’ll receive a $400 tax refund and can invest more than your original $2,000.
Making the Most of Your Account
The US government approves tax-deferred savings plans for a reason. Again, they want to encourage Americans to save for retirement. These financial vehicles make it easier for people to contribute a part of their pre-tax earnings into an investment account.
Every year, you can reduce your taxable income by the amount you contribute to a tax-deferred retirement plan. The money you contribute will get invested into a mutual fund or other investment vehicles. In this way, you can build a nest egg that grows until you retire.
Accessing Your Savings Before Retirement
In some instances, you can withdraw money from your tax retirement plan without incurring a penalty. However, your withdrawal must meet one of several requirements. If it does, you could withdraw funds without facing an early withdrawal penalty.
For example, you may want to withdraw funds from your tax-deferred retirement plan to buy your first home. Alternatively, you can withdraw funds from your plan without penalty if you become disabled.
Otherwise, a beneficiary would not have to pay taxes on a tax-deferred retirement plan if it was gifted to them in the event of the taxpayer’s death. You may also withdraw funds for medical expenses or college tuition without penalty.
Tax-Deferred Annuity Contribution Limits for 2022
With tax-deferred annuities, you can save a considerable amount more toward your retirement. Let’s have a look at tax-deferred annuity contribution limits for 2022.
If you’re under 50 years old and have worked at a company for less than 15 years, you can contribute up to $20,500. If you’re under 50 and have worked at the same company for more than 15 years, you can contribute as much as $23,500 per year.
If you’re over 50 and you’ve worked at a company for less than 15 years, you can contribute up to $27,000 to a tax-deferred retirement plan. However, if you’re older than 50 and have worked at a company for more than 15 years, you could contribute as much as $30,000 to your tax-deferred annuity retirement plan.
Your Contribution Limit Can Change
It’s important to note that the maximum contribution limit for a tax-deferred annuity retirement plan can change. The results of your maximum contribution calculations can vary depending on several factors. Also, the maximum limit could change from year to year.
For instance, your tax-deferred annuity limit might increase if you receive additional compensation like bonuses. It could also increase if you turn 50 years old and become eligible to withdraw your contributions. Alternatively, your tax-deferred annuity limit could decrease if you contribute to a 403 (b) or 401(k) plan with your employer.
Tips for Saving More
The thing to remember about tax-deferred retirement savings is that it costs you less to contribute more. Also, it’s never too late to start saving or increasing your retirement contributions.
You’re off to a good start if you’re contributing the maximum amount to your workplace retirement plan. A tax-deferred annuity plan can help you to save more.
It’s also a good idea to consider a traditional IRA or Roth IRA if possible. If you’re self-employed, you might look into a Simplified Employee Pension (SEP), IRA, or Keogh retirement savings plan. Also, anybody can invest after-tax money in mutual funds, a standard investment portfolio, or after-tax annuities.
Learn More About Managing Your Finances
Hopefully, our guide to tax-deferred retirement plans has you well on your way to saving toward comfortable living in your golden years. This added capital can make a considerable difference in your retirement savings over time.
There’s plenty more you can learn about managing your finances. Please feel free to browse our Finance section to learn more about making the most of your money.
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