To encourage people to save and invest for retirement, the IRS allows for retirement accounts that provide tax breaks. Two of the three main varieties of retirement accounts, 401(k)s and traditional IRAs, give tax breaks in the form of tax deductions. Tax deductions allow you to subtract your contributions from your taxable income, which lowers your tax bill and saves you money. For example, if you make $100,000 and have $10,000 in tax deductions, only $90,000 of your income will be taxed.
Tax deductions can be a two-for-one benefit for investors: you can save money in the present with a lower tax bill, as well as put yourself in a good financial position in retirement. If you have the option, it’s in your best interest to take advantage of a 401(k) and traditional IRA.
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The 401(k) is the most popular type of retirement account, largely because it’s offered by employers to their employees, and many people are automatically enrolled in a plan. It differs from other retirement accounts because your contributions to it are automatically taken from your paychecks pre-tax. Once you’ve set up your 401(k), you don’t have to go out of your way to keep investing; your contributions are allocated into your preselected investments each time you get paid.
Among the primary types of retirement accounts, 401(k)s have the highest annual contribution limit — $20,500 this year, or $27,000 if you’re 50 or older — so they give you the biggest opportunity to lower your taxable income. It may not be feasible for you to max out your 401(k) contributions if you’re making less than six figures, but it’s definitely doable if you find yourself closer to the $150,000-plus range. Making $150,000 annually, you can max out your 401(k) by contributing 13% of your paycheck.
Imagine you’re single, under 50, and make $180,000 annually, putting you in the 32% marginal tax bracket. The $12,950 standard deduction — which anyone can use to lower their taxable income if they’re not itemizing deductions — and $20,500 in 401(k) contributions would bring your taxable income to $146,550, which is in the 24% marginal tax bracket. That alone would save you over $3,000 in federal income taxes.
Traditional IRA deductions
Although anyone can contribute to a traditional IRA (unlike Roth IRAs, which have income limits), not everyone is eligible to deduct their contributions. Whether you’re allowed to make a deduction, and how much, depends on your tax filing status, income, and whether or not you’re covered by a retirement plan at work.
Here’s how much of your traditional IRA contributions you can deduct if you are covered by a retirement plan at work:
|Tax filing status||income||Deduction Allowed|
|single||$68,000 or less||Full amount up to contribution limit|
|single||$68,001 to $77,999||Partial amount|
|single||$78,000 or more||No deduction allowed|
|Married, filing jointly||$109,000 or less||Full amount up to contribution limit|
|Married, filing jointly||$109,001 to $128,999||Partial amount|
|Married, filing jointly||$129,000 or more||No deduction allowed|
|Married, filing separately||Less than $10,000||Partial amount|
|Married, filing separately||$10,000 or more||No deduction allowed|
Here’s how much of your traditional IRA contributions you can deduct if you are not covered by a retirement plan at work:
|Tax filing status||income||Deduction Allowed|
|single||Any amount||Full amount up to contribution limit|
|Married, filing jointly or separately (with a spouse not covered by a work plan)||Any amount||Full amount up to contribution limit|
|Married, filing jointly (with a spouse who is covered by a work plan)||$204,000 or less||Full amount up to contribution limit|
|Married, filing jointly (with a spouse who is covered by a work plan)||$204,001 to $213,999||Partial amount|
|Married, filing jointly (with a spouse who is covered by a work plan)||$214,000 or more||No deduction allowed|
|Married, filing separately (with a spouse who is covered by a work plan)||Less than $10,000||Partial amount|
|Married, filing separately (with a spouse who is covered by a work plan)||$10,000 or more||No deduction allowed|
Look at tax-favored retirement accounts
Any amount of saving for retirement is a good thing. But it can be that much better if you can get a tax break for it as well. Look closely at 401(k)s and IRAs and see if they’ll work for you.
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