Social Security provides enough of an income to the elderly to maybe ensure against utter deprivation, but realistically you need to think ahead and do what you can to make sure that’s not the only money you will have when you retire. Luckily the government does provide certain tax benefits to facilitate saving for retirement. Let’s look at three of these:
1. Contributions you make to a traditional IRA, 401(k), or other qualified retirement savings plan are subtracted from your income before you calculate your taxes. So if you make $60,000 in income this year, and you take $5,000 of that and place it in a retirement savings plan, your taxes will be calculated as if you’d made only $55,000. This obviously reduces your tax bill for this year, perhaps substantially.
2. Related to the above, you are not taxed on money placed in a traditional IRA, 401(k), or other qualified retirement savings plan until you actually withdraw the money.
What’s good about this is most people make far more money per year during their working years than during their retirement. So they end up paying taxes on the money from their retirement savings plans when they’re in a lower tax bracket.
For instance, let’s say you make $80,000 this year in taxable income (wages, interest, dividends, etc.). And you set aside $8,000 of that in your retirement savings plan. Then ten years from now, when you’re retired, in a year where you have only $25,000 in taxable income, you pull out $8,000 from your retirement savings plan to supplement that. The upshot is this year you’ll have income of $72,000 and that future year you’ll have income of $33,000. Whereas otherwise you’d have income of $80,000 now and $25,000 later.
Why does that matter? Because when you increase your income from $25,000 to $33,000 in a given year, you pay significantly less in taxes on that $8,000 difference than when you increase your income from $72,000 to $80,000 in a given year, due to the fact that higher incomes are taxed at a higher rate.
Meanwhile, you’re not only deferring taxes on this retirement money until a more favorable tax year, it’s also likely increasing in value in the interim, depending on how you have it invested.
3. In 2008, the government instituted a new “Retirement Savings Contribution Credit” that many low income taxpayers who contribute to a qualified retirement savings plan will be eligible for. The amount of the tax credit varies with income. For those with an income of $16,000 or less ($32,000 for couples filing jointly), if they are able to somehow set something aside for retirement in such a year, they will get a tax credit equal to a whopping 50% of it. From $16,000 to $17,250 ($32,000 to $34,500 for couples filing jointly), the credit is 20%. From $17,250 to $26,500 ($34,500 to $53,000 for couples filing jointly), the tax credit is 10%.
It’s not always easy to set aside money for retirement when there is so much you’d like to spend it on now, but if you can exercise the self-discipline to do so, there are ways the government will reward you and make that money go even a little farther than it otherwise would.
For more information on these and other tax matters, see www.irs.gov.