Q: I know you can deduct certain retirement savings contributions, but not others. How do these tax benefits work?
There are several types of tax-advantaged retirement savings accounts – 401(k)s, 403(b)s, traditional IRAs, Roth IRAs, SEP-IRAs, Thrift Savings, and 457 plans, just to name some of the most common. However, the contributions to all of them can be divided up into two broad categories: those that get you a tax break now, and those that get you a tax break later.
Those that get you a tax break now include most 401(k) contributions (which are generally taken pre-tax from your paycheck) and all traditional IRA contributions. Investing money through these types of accounts will lower your taxable income for the current tax year. For example, qualifying traditional IRA contributions of up to $5,500 ($6,500 if you're 50 or older) will reduce your 2017 taxable income.
The catch is that when you take the money out of these retirement savings vehicles later, those withdrawals will count as taxable income.
On the other hand, there are the accounts for which contributions don't provide any immediate tax breaks (also known as Roth contributions), but for which qualifying withdrawals are 100% tax-free. This means you'll pay no taxes on your profits from the investments held in them, which makes them a solid way to reduce your tax bills in retirement.
Finally, for those taxpayers with low to moderate incomes, contributions to all qualifying retirement accounts are eligible for the Saver's Credit. Formally known as the Retirement Savings Contributions Credit, this can cut your tax burden by up to $1,000 per year.