You have worked hard to build your big American dream. You have given your children a good childhood and sent them off to premier universities. And now, it’s time for you to retire. But taxation does not care much about your retirement. How do you maintain the life that you have so painstakingly created for yourself without losing out a major chunk of your savings on taxes?
To make sure that you don’t end up giving away quite a bit to Uncle Sam, there are a few measures you can take before you retire. In this article, we will look at what types of income will be taxed upon retirement, and what are the different strategies and plans you could adopt to live a comfortable retired life.
Retirement schemes and tax plans you can invest in
- Defined contribution plans – It is a workplace retirement plan in which typically the employee and the employer make matching contributions. This is helpful as sometimes social security benefits alone may not be enough in the future.
The most popular one that is ubiquitous all over the US is the 401(k). It may require you to wait up to one year before you enroll.
In a traditional 401(k), an employee contributes with his pre-tax dollars. So, the contributions do not come under taxable income. These contributions then grow tax-free until you withdraw them at retirement. This is one of the easiest and most low-effort ways to save for the future as you can schedule for the money to come out of your pay check and be invested in the plan automatically. For the year 2022, the employee’s contribution limit is $20,500 ($27,000 for those aged 50 and over). The money can be invested in high-return investments such as stocks.
Coming to the “matching contribution” made by the employer, it depends on the employer itself. Different employers use different formulas to determine their match. Some offer a dollar-for-dollar match while others use a tiered approach offering different percentages for different levels of employee contributions.
One of the key disadvantages to a 401(k) is that you might have to pay a penalty if you make an early withdrawal.
A Roth 401(k) allows you to contribute after-tax dollars. As a result, your withdrawals will be tax-free.
A 403(b) is similar to a 401(k), but it is offered only by public schools, charities, and some churches. A 457(b) is another such similar plan that is available to employees of state and local governments.
- Solo 401 (k) – It is also called a one-participant 401(k), solo-k, uni-k. This plan is fit for a business owner and his or her spouse as they are both the employer and the employee. The owner can contribute both elective deferrals and employer non-elective contributions.
Elective deferrals of up to $20,500 can be made along with a non-elective contribution of up to 25% of the compensation. The total can go up to $61,000 excluding catch-up contributions.
IRC Section 402(g) limits the number of elective deferrals a plan participant may exclude from taxable income each calendar year. If elective deferrals weren’t limited to the amounts under IRC Section 402(g), then the excess deferrals need to be redistributed. If the limit is exceeded and it is not corrected, the plan could be disqualified. If an employee has elective deferrals in excess of the 402(g) limit under one or more plans of an employer, each plan is subject to disqualification.
- IRA plans– It is an Individual Retirement Account that helps you save money for retirement while also having tax advantages. Unlike a 401(k) there is no component of matching contribution by an employer here. (You can contribute a traditional or Roth IRA even if you have an employer-sponsored retirement plan!)There are many different types of IRA – each with its own advantages and disadvantages.
- Traditional IRA– Anyone who earns money can be a part of the traditional IRA by contributing pre-tax dollars. The contributions grow tax-free and become taxable only when you withdraw them at retirement. The reasons for its popularity are that you do not owe taxes until withdrawal, and its limitless number of investment options like stocks, bonds, real estate, etc. But the disadvantage here is the investments will have to be made yourself. The decisions should be made by you. A traditional IRA is the best option if your employer does not offer a 401(k).
The maximum amount you can contribute to an IRA for the year 2022 is $6,000. If you are 50 or older, you can contribute up to $7,000.
The traditional IRA contribution is deductible in full on the tax return if neither you nor your spouse is covered by a retirement plan at work.
The amount that can be deducted is limited if you or your spouse are covered by a retirement plan at work and exceed certain income levels.
For those with filing status as single/head of household, if your MAGI is $78,000 or more, then you cannot claim deductions; if your MAGI is more than $68,000 but less than $78,000, then you can claim partial deductions.
For those with filing status as married filing jointly, if your MAGI is $129,000 or more, then you cannot claim deductions; if your MAGI is more than $109,000 but less than $120,000, then you can claim a partial deduction.
- Roth IRA–In this type of Roth IRA, you make contributions from your after-tax dollars. Consequently, you will not have to pay tax when you make withdrawals. This is a great option also because it lets you take out your contributions, not gains, at any time without any penalty. The contribution limit is the same as that of a traditional IRA but the contributions are not deductible on your tax return.
- Spousal IRA – Usually, IRAs are reserved only for those who have an earned income. But in a spousal IRA, the spouse of such a worker can also contribute to an IRA as well. This is advantageous to non-working individuals as they get the benefits of an IRA that a working individual would.
The condition here is that the couple must file taxes as “married filing jointly”. The IRA is also not co-owned; it is strictly in the name of the non-working spouse.
Just like a traditional IRA, a couple can deduct the full contribution to a spousal IRA if neither is covered by a retirement plan at work.
- Simplified Employee Pension (SEP) IRA– It is set up like a traditional IRA but for small business owners and their employees. Only the employer contributes to this account for each employee. The limit is 25% of the compensation or $61,000, whichever is lesser. Like a traditional IRA, the contribution is made pre-tax and the growth occurs tax-free.
What if I make an excess IRA contribution?
An excess IRA contribution occurs if you contribute more than the limit or make an improper rollover contribution to an IRA. These excess contributions are taxed at 6% per year for each year that the excess amount remains in the IRA.
In order to avoid this tax, you need to withdraw the excess contribution and also any income on the excess contribution.
- Health Savings Account – An HSAis considered triple tax-free i.e you contribute pre-tax dollars, pay no taxes on earnings, and withdraw the money tax-free to pay for qualified medical expenses. It can also be used as a retirement vehicle and be used to save the maximum per year. If these funds are not used before retirement, then taxation wise an HSA behaves just like a 401 (k). After retirement, they can be used for a range of qualified healthcare expenses.
The tax treatment of HSAs gives it the potential for greater investment growth and greater after-tax balance accumulation when compared to other retirement options. Assuming you use HSA funds to pay for qualified medical expenses, you do not pay any federal taxes. That’s why it is one of the best and most tax-efficient investment options for your retirement.
The 2022 IRS contribution limits for HSAs are $3,650 for individual coverage and $7,300 for family coverage.
As seen, each plan offers benefits of its own. Some provide tax advantages at the time of contribution, whereas others like Roth IRA provide advantages at the time of withdrawal. It would be prudent to take the help of a CFO consultancy service to help you decide on a suitable one.
A bonus advantage by the government
As an incentive to push you towards saving for retirement, the government also offers the Saver’s credit.
It is a tax credit worth up to $2,000 ($4,000 if married and filing jointly) for mid-and low-income taxpayers who contribute to a retirement account. You are eligible for this if you have an IRA and have an AGI under $34,000 if you are a single filer, under $51,000 if you are a head of household, and under $66,000 if you are a married joint filer. The value of the saver’s credit is calculated based on your contributions to the IRA. You may be eligible for 50%, 20%, or 10% of the maximum contribution amount; it depends on your filing status and AGI. It is beneficial as it reduces your tax bill dollar-for-dollar.
Read this to know more about the other taxes you might have to pay upon retirement.