Now is a good time to review and evaluate your retirement savings. The tax code provides significant incentives for individuals to make contributions to retirement savings and plans, including traditional and Roth IRA’s, as well as to employer sponsored qualified and non-qualified plans, including qualified 401(k) plans. A saver’s credit also may be available for investors in certain tax brackets, which further enhances overall savings. The tax law is designed to make it easy for individuals to save for retirement.
Tax incentives can include deductibility of contributions, tax deferral on growth of assets in the plan, and potential distribution free of tax, varying on the investment vehicle chosen. The choice of investment that may be best for you depends upon your individual tax and overall financial situation. Regardless of the type of contribution, any contribution should be made as early in the year as possible. If this approach is followed consistently over the years, the benefits will be far greater than contributions made at the last minute.
Employees make contributions to a 401(k) plan through a reduction in salary using pre-tax dollars—an “elective deferral.” In other words, the amount of an employee’s contribution reduces his or her wages and is not included for purposes of W-2 reporting. However, the salary reduction amount is included for purposes of Social Security and Medicare taxes. This way, employees are not penalized by losing Social Security credits for the amount of their 401(k) contributions. To encourage employee participation in a 401(k) plan and to help make sure these plans are not discriminatory, employers often make matching 401(k) contributions.
There are two specific inflation-adjusted limitations placed on the amount of 401(k) contributions in any one year. The first limitation is a limit on the amount of an employee’s elective deferrals. The second is an overall limit on contributions, including employer contributions. For 2020 and for 2021, participants can make 401(k) contributions through elective deferrals of up to $19,500. Those who are age 50 or older can make additional “catch-up contributions” of up to $6,500, for a total of $26,000 in 2020 or 2021. Including employer contributions, the maximum 401(k) contribution is the lesser of $58,000 for 2021 ($57,000 for 2020) or 100 percent of compensation.
Individual Retirement Account
An individual retirement account (IRA) is a retirement vehicle in which a taxpayer can contribute pre-tax or after-tax dollars. Unlike a 401(k) plan, which are offered by taxpayer’s employers, most IRAs are ones that taxpayers set up themselves. The types of IRAs are:
- Traditional IRA. An IRA that allows a taxpayer to deduct contributions on their income tax return. A taxpayer may also elect to treat deductible contributions as nondeductible. Earnings in the IRA are allowed to grow tax-deferred and are only subject to income tax when they are distributed. There is no age limit for making contributions. Distributions are required to be taken annually when the IRA owner reaches age 72. The taxpayer may not be able to deduct all contributions if the taxpayer or the taxpayer’s spouse participates in a retirement plan at work.
- Roth IRA. An IRA that is generally subject to the rules that apply to a traditional IRA. Unlike a traditional IRA, however, a taxpayer cannot deduct contributions to a Roth IRA and qualified distributions from a Roth IRA are tax free. In addition, contributions can be made to a Roth IRA at any time, and distributions are not required to be taken from a Roth IRA while the taxpayer is alive. The taxpayer’s Roth IRA contribution can be limited based on filing status and income.
For 2020, total contributions to all of a taxpayer’s traditional and Roth IRAs cannot be more than the lesser of: $6,000 ($7,000 for those age 50 or older), or their taxable compensation for the year.
Self-employed taxpayers may also participate in a SEP (Simplified Employee Pension Plan) IRA or SIMPLE (Savings Incentive Match Plan for Employees) IRA Plan.
Please call our office to discuss your retirement savings situation and strategy. The rules applicable to the types of investment vary and can be complex. We will be happy to help you maximize your tax benefit and overall savings.
Niki Matthews, CRTP