Three-step approach to reducing your tax bill and saving more for retirement

We’ve all heard that old adage that the only certain things in life are death and taxes. Gallows humor aside, paying more than you have to in income taxes is not entirely inevitable. We discuss three common ways to help temper your annual tax burden so that you can save more for your retirement.

1. Contribute to a 401(k) Plan

If you participate in a 401(k) plan, one of the advantages is that your payroll contributions may lower your taxable income, either now or in the future. As you may already know, there are a few methods by which to contribute to your retirement plan: on a pre-tax basis, an after-tax basis, or a combination of both.

In a traditional 401(k) plan arrangement, your contributions are taken out of your salary on a pre-tax basis—that is, you contribute to your retirement savings before state and federal governments take their share of the rest. Your contributions then grow tax-deferred, which means you don’t pay taxes on them until you withdraw money from your account, typically in retirement.

The tax benefit of making a traditional pre-tax contribution is the reduction of your taxable income today. This may be advantageous to a saver that is currently in his peak earnings or highest tax bracket years. At retirement, you may be earning less money, and therefore be taxed at a lower rate than  you would be today. The challenge is that salaries and tax codes are not set in stone, and there’s no way to predict what these will be for you—or how your investments will perform until you retire.

Another tax-advantaged option to funding a 401(k) plan is by electing an after-tax choice, such as Roth. Roth 401(k) contributions allow a participant to defer his tax payments to retirement. While you will get no deduction up front, your money can be saved year over year in a tax deferred account and when you reach retirement you can withdraw your contributions and earnings tax-free. There are a few conditions to this, however: withdrawals generally must be made after you’ve reached age 59½ and you must have had your Roth 401(k) account for at least five years.

Choosing Roth 401(k) may be advantageous to a saver at the beginning of his career, for those making a relatively modest salary, or for those expected to make significantly more in the future. These savers may benefit from having a lower tax bracket today paying taxes now. In addition your plan investments may grow over the course of your working years which would also be tax free at retirement. While this may seem like an attractive option to many, it’s important to consider the Roth rules. If you want to withdraw your savings before the five-year holding period, or before you attain age 59½, you may be taxed and penalized. Additionally, future investment performance, salary levels and tax brackets are not predictable.

Combining pre-tax and after-tax contributions is a potential third option that could maximize the benefits of each choice for certain periods of time. If you have a pre-tax rollover 401(k) where you’ve consolidated traditional accounts from previous employers, you may choose to utilize a Roth contribution going forward to diversify your tax position. Again, it is always recommended that you seek the advice of a tax professional to determine the savings method that is best for your personal situation.

2. Use Tax Deductions and Credits

Tax deductions and credits can be used together to lower your overall tax burden. They are used differently.

First, tax deductions lower your taxable income, thereby reducing the amount of money you’re taxed by the government. You may be able to deduct from your taxable income:

  • Medical expenses, to the extent they exceed 7.5% of your income;
  • Homeowner deductions for mortgage interest and property tax bills;
  • Business or personal expenses such as the costs involved in running a side or home business; or
  • Charitable donations.

In general, the following items may be used as a tax credit. The amount of the tax credit is applied to your tax bill to lower it:

  • Child tax credits for children under 17, if you do not exceed adjusted gross income limits;
  • Education credits for your children or yourself if you meet “qualified student” guidelines and do not exceed adjusted gross income limits;
  • Child and Dependent Care Credit for children or adult dependents if you do not exceed adjusted gross income limits; and
  • Energy-saving credit for efficient furnaces, water heaters, air conditioners and solar panels in your principal residence.

As the rules and credit amounts change from year to year, you should discuss these issues with a tax attorney or accountant.

3. Choose the Proper Withholding

Getting a significant refund back on your taxes may mean you’re having too much withheld from each paycheck, essentially giving the government a free loan on your money. Sure, it’s nice to have no tax liability, but this is also money you could have used to invest in your future. Decreasing your tax withholding is an easy way to increase your contribution to your 401(k) plan by a percentage or two. It’s money you’re already not using or spending. In fact, you may be surprised how saving just 1% more could positively impact your retirement savings over a long period of time.

While this three-step approach may prove beneficial to most, you should always consider your specific situation and seek personalized guidance on this complex topic by consulting with your tax professional.

 

Press inquiries: Christine Hotwagner
Director, Program Operations
ABA Retirement Funds
JoinUs@ABARetirement.com

Please click here to view the latest Program investment information.

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