Contributing to your retirement accounts is an important investment into your financial future—but it can offer you some tax benefits too. It’s important that you consider both the immediate and future tax implications of your retirement contributions so that you can take control of your finances and your retirement. But which type of retirement account will give you the biggest tax benefit? The answer could vary based on your specific financial situation and retirement goals, so you should speak to one of our accountants in Provo. But this article will give you a quick overview of the different types of retirement accounts and how they can impact your taxes.
Traditional IRA
A traditional IRA is typically set up through your bank, but can also be established via your stockbroker, mutual fund, or life insurance company in some situations. They’re fast and easy to set up, so it’s a good idea to establish one of these for yourself if you haven’t already. The maximum contribution for IRA accounts is relatively low, with the limit for 2020 set at $6,000. (If you’re over 50, you can put in up to $7,000 per year.)
Contributions to a traditional IRA are considered a pre-tax contribution. Because deposits to these accounts are typically made with personal funds—which have already been taxed—this means that you can write off all of your contributions to a traditional IRA when you file your tax return. This reduces your overall tax liability so that you owe less or will get a larger refund.
While this is obviously an excellent and immediate tax benefit, it is important to be aware that this means all distributions from these accounts are taxable. So, when you retire and begin to withdraw funds from your traditional IRA, you will have to pay taxes on it. You should also know that you’re not allowed to withdraw from these accounts until you’re 59 ½, except under certain circumstances; if you do, the funds may be subject to an additional 10% fee, plus the usual taxes.
Roth IRA
Despite the similarity in their names, the tax implications of a Roth IRA are quite different from those of a traditional IRA. Deposits to a Roth IRA are post-tax, so you can’t write them off on your tax return. However, that does mean that you won’t be taxed when you withdraw from these accounts after retirement, so they can be an excellent tax-free income source for your future.
Roth IRAs are subject to most of the same limitations and regulations as a traditional IRA, including maximum contributions. Please note that the maximum contribution for IRA accounts is for all your IRAs combined. So, if you deposit $3,000 into your traditional IRA and $3,000 to your Roth IRA, you have maxed out your contributions to both accounts for the year.
401(k)s
Unlike both types of IRAs, a 401(k) is not typically established through a financial institution; instead, you will usually set it up through your employer. Contributions to a 401(k) are also pre-tax, and are typically taken directly out of your paycheck before taxes are applied. If this is how your deposits to your 401(k) are being made, this means that (unlike with a traditional IRA) you cannot write off the contributions, as those funds were never taxed. In some cases, employers even offer a contribution matching program for employees.
401(k)s have a much higher contribution limit than IRAs, with the limit for 2020 being set to $19,500. If you’re over 50, you can contribute an additional $6,500 per year, for a maximum annual contribution of $26,000. This often makes them the primary retirement account for many workers.
Where Should You Contribute?
So, if you have to choose which account to invest in, where should you put your retirement funds? Which one will offer you the greatest tax benefit? As we’ve already mentioned, the answer can vary depending on your specific goals and finances, but here’s a good general guideline:
If your employer offers contribution matching for your 401(k), max out the amount that they’ll match before you put money into other retirement accounts. It’s generally a good idea to diversify your retirement funds and have both taxed and untaxed sources of income. So, since your 401(k) withdrawals will be taxed in retirement, your next step should be maxing out your Roth IRA. Once you have done this, if you still have funds to invest in your retirement accounts, max out your 401(k).
Now, you might be wondering, “What about the traditional IRA? Do I even need one?” Remember, the above is just a general guideline. Traditional IRAs can be valuable if you plan to be in a lower tax bracket when you retire than you are now; this is common for many retirees. If this is the case, you may choose to invest your funds into your traditional IRA instead of your Roth IRA, because you’ll pay less tax on those funds when you retire.
If you need assistance deciding where to place your retirement funds, give us a call. We’ll discuss your retirement goals with you and let you know which accounts will provide you with the greatest tax benefit based on your financial situation. Contact The Accounting Guys today to speak with one of our expert accountants in Provo today.