Looking to make the most of your retirement savings while minimizing your tax liabilities? We’ve got you covered. Here’s how to take advantage of the tax benefits of your retirement plans.

Employer-Sponsored Retirement Plans

A lot of employers offer 401(k), 403(b), or 457(b) plans for their employees. If you sign up for one of these plans, you can choose to contribute pre-tax dollars or after-tax dollars to your retirement plan.

Tax-Deferred Growth

Suppose you contribute pre-tax dollars to your retirement plan, your contributions will grow tax-deferred.

Tax-deferred growth means that any earnings or gains on your investments within the account are not subject to immediate taxes. Instead, taxes on the growth are postponed until you withdraw the funds in retirement. This allows your investments to grow faster over time since you can reinvest the money that would have otherwise gone towards taxes, maximizing your retirement savings.

Remember, you will have to pay taxes on both your contributions and income once you start withdrawing from your retirement plan, but not before.

Tax-Free Growth

Alternatively, suppose you contribute after-tax dollars to your retirement plan, your contributions will grow tax-free. The option to contribute after-tax dollars to these plans is known as a “Roth option”.

Tax-free growth in a Roth plan means that any earnings or gains on your investments within the account are not subject to taxes while the funds are growing and upon withdrawal in retirement.

This allows your investments to potentially grow faster and accumulate more wealth over time. The tax- free growth feature is a significant advantage, providing greater financial flexibility and potentially reducing your overall tax burden during retirement.

Maximize Contributions

The IRS releases annual adjustments for the maximum contribution limits for 401(k), 403(b), and 457(b) plans. As of 2023, the limit on annual contributions for these retirement plans is $22,500.

Catch-Up Contributions

If you are 50 years or older, you can make additional contributions of up to $7,500 for 2023.

If possible, you should contribute the maximum allowed to your employer-sponsored retirement plan because there are significant tax benefits.

Choosing Between Pre-Tax or After-Tax Contributions

So, how do you choose whether to contribute pre-tax dollars or after-tax dollars to your 401(k), 403(b), or 457(b) plan? The contribution of pre-tax dollars can be a good strategy if you think you will be in a lower tax bracket during your retirement years. A lower tax bracket means paying taxes at a lower tax rate because you will have lesser taxable income. So, in this case, you will not pay taxes now but pay lower taxes during your retirement.

On the other hand, contributing after-tax dollars to your retirement plan can be beneficial if you anticipate being in a higher tax bracket during your retirement years. A higher tax bracket implies paying taxes at a higher tax rate as you will have more taxable income. You may lose some tax credits or deductions and end up with higher taxable income during your retirement. So, in this scenario, you would rather pay taxes now and have your money be tax-free during your retirement years.

Traditional IRA

A traditional IRA, short for “Individual Retirement Account”, contributes pre-tax dollars toward individual’s retirement, potentially lowering their current tax liabilities. The funds in a traditional IRA grow tax-deferred until withdrawal during retirement when they are subject to ordinary income tax. So long as you’re under the income limits set by the IRS, you can contribute up to $6,500 per year to an IRA.

Tax Deduction

While we love the idea of tax-deferred growth, traditional IRAs also offer the potential tax deduction for contributions. The IRS restricts this tax deduction based on various factors, especially your modified adjusted gross income (MAGI).

· If you and your spouse are not covered by an employer retirement plan, such as a 401(k), your IRA contributions are fully tax-deductible.

For example, let’s say you are a single filer with no employer retirement plan and a MAGI of any amount. You can then deduct your full contribution amount. So, if you made $50,000 and contributed $5,000 to your traditional IRA, your taxable income would be reduced to $45,000.

For a married couple under the same circumstances, the same rule applies.

· If you or your spouse have an employer contribution plan, your IRA contributions may be partially tax-deductible or completely non-tax-deductible, as determined by the IRS.

Let’s take the above example of the $50,000-a-year single filer, except this time they have a 401(k) too. As long as they make $73,000 or less, they still get the full deduction. If they made more than that amount, they would either get a partial deduction or no deduction. For the couple, the cut-off is $116,000 for the full deduction.

Roth IRA

Unlike a traditional IRA, contributions to a Roth IRA are made with after-tax dollars, meaning you’ve already paid taxes on the money. The key benefit is that qualified withdrawals from a Roth IRA, including both contributions and earnings, are tax-free in retirement. Additionally, Roth IRAs have flexible withdrawal options and no required minimum distributions, providing more control and potential for tax- efficient planning during retirement.

Maximize IRA Contributions

As of 2023, the limit on annual contributions for the traditional and Roth IRAs is $6,500. This total amount is across all IRAs, so you could have $3,000 in a traditional and $3,500 in a Roth, for example.

Be careful not to exceed that limit or you could face an excess contribution penalty – often 6% of the excess contribution annually until you remove the excess amount.

IRA Catch-Up Contributions

If you are 50 years or older, you can make catch-up contributions of up to $1,000 extra. This group could max out their traditional or Roth IRA contribution, totaling $7,500 for 2023.

Retirement Savings Withdrawals

To fully take advantage of the tax benefits of your traditional or Roth IRA, you should let the funds grow for as long as possible.

Ideally, you should be at least 59.5 years old before withdrawing from a traditional IRA to avoid an early withdrawal penalty of up to 10%. Be sure you also meet the required minimum distributions (RMDs) after age 72 to avoid penalties.

On the other hand, if you have a Roth IRA, it is recommended that you hold it for at least 5 years and be at least 59.5 years old before withdrawing to avoid a penalty fee. Certain qualifying events, like disability or using the funds for a home, could allow for penalty-free withdrawals even if you don’t meet these criteria.

The Roth Conversion Ladder

Another strategy for withdrawing from a traditional IRA is the Roth conversion ladder, where you slowly convert a traditional into a Roth over several years. This keeps your taxable income within a lower tax bracket, lowering your tax burden in retirement.

Conclusion

Retirement investing is something that gets put on the back burner for many of us. As a result, thousands of investors miss out on the potential tax savings they could accrue if they had taken advantage of the tax benefits of the retirement plans.

Luckily, it’s not too late. Take advantage of the tips we’ve covered here today and start on tax-advantaged retirement planning.