The first rule of retirement planning is: it’s never too early to plan for retirement. One crucial aspect of this planning is understanding the tax advantages and implications associated with different retirement savings accounts. Some of the advantages of retirement savings are tax deferred wealth growth, deferred taxable income, and credits that are incentives for retirement savings. There are several different types of retirement accounts, including 401Ks, IRAs, SEP Plans, and Simple IRAs.
Probably one of the biggest and yet least noticeable benefits of putting money into a retirement account is the ability for those funds to grow without affecting taxable income. Interest income, dividends, and capital gains are reinvested into retirement savings allowing an increase in wealth, but still deferring the taxes paid on that income until withdrawn during retirement. Money invested in a retirement account can compound over time and allow you to live more comfortably during retirement. Depending on how you invest this could give you the biggest benefit to deferred income.
For high earners, investing money into retirement is one of the easiest ways to decrease your taxable income. As long as contributions are made to a 401(k) or a Traditional IRAs, you can lower your taxable W-2 income with some limitations to how much income can be deferred. The IRS also gives tax credits to encourage lower income individuals to plan for retirement, such as the Saver’s Credit.
Diversification is smart method to take advantage of tax credits and increase your retirement savings. Different types of retirement accounts include:
401(k) Plans: this type of retirement account is usually offered by an employer as part of your employee benefits. Contributions can be made to the account via a reduction in your taxable W-2 income. Then the employer will typically match a percentage to that contribution, which is additional income that you are not taxed on until you withdraw the funds. There are limitations to how much can be deferred to a 401K account.
Traditional IRAs: IRA stands for Individual Retirement Account. It’s a retirement account typically opened up by an individual through a financial institute such as a bank or mutual fund. Since an IRA is opened by an individual, there are no employer contributions and the contribution limitations are typically lower than those for employer sponsored plans. Contributions are still a reduction in income and can provide a tax benefit, plus since it’s an individual account, you are able to diversify your investments and enhance the retirement accounts chances of growing.
Roth IRAs: In contrast to a traditional IRA, contributions to a Roth IRA are made post-tax, which means the contributions are not tax deductible. However, when you reach retirement age and start making draws on the account, they will be tax free.
SEP IRA: SEP stands for Simplified Employee Pension. This type of retirement plan is retirement plan is eligible for businesses of any size and with this plan only the employer is allowed to contribute money. SEPs are attractive to small businesses because they are easy to operate and have low administrative costs. Employers can contribute up to 25% of an employee's pay to this type of IRA, but they must contribute equally for all employees. An SEP is particularly suitable for S-Corporation owners because you can contribute a significant amount of business income towards retirement.
Simple IRAs: SIMPLE stands for Savings Incentive Match Plan for Employees. This type of retirement plan is also suitable for small businesses, and it allows both the employer and the employee to contribute. It is easy and inexpensive to set up and shares the responsibility of retirement with the employee. It does, however, have inflexible contribution requirements and lower contribution limits than other retirement plans.
HSA Accounts: Although not technically a retirement plan, HSA accounts, short for Health Spending Accounts, have increasingly become a more popular way of deferring income. This is because not only are the contributions made to an HSA account able to be made tax free, but as long as the withdrawals are used for approved health care expenses, any draws on the funds available in an HSA account are also tax free. There are annual contribution limits, but unused funds roll over year after year and it’s safe to assume that most retirees will have medical expenses they can use the funds for.
Retirement is a part of life most people look forward to. Understanding the tax advantages of retirement savings and the different retirement account options is crucial for building a secure financial future. By taking advantage of these tax benefits, you can maximize your savings and prepare for a comfortable retirement. We can always recommend a financial advisor you can consult with to determine the best retirement accounts for your unique circumstances and start securing your nest egg.
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