If there's one thing most Americans can agree on, it's that they don't like paying taxes. But no matter how much you earn, you have a real opportunity to lower your tax burden and give less of your money to the IRS year after year. It's called contributing to a tax-advantaged retirement savings plan, and it's a move that can not only slash your tax bill but also ensure that you have enough money to live comfortably in the future.
The benefit of funding an IRA or 401(k)
You should be motivated to save independently for your golden years without a tax break. The reason? Social Security won't provide enough income for you to live on in the future. In a best-case scenario, those benefits will replace about 40% of your income if you're an average earner, but most seniors need roughly twice that amount to maintain a reasonable standard of living. Throw in the fact that Social Security benefits could face universal cuts in the not-so-distant future, and it's pretty clear that relying on them in the absence of other income is a bad idea. And often, that other income comes in the form of an IRA or 401(k).
But let's get back to the tax breaks associated with these accounts, because if you're on the fence about opening one, they should really tip you over the edge. When you fund a traditional IRA or 401(k), the amount you contribute goes in on a pre-tax basis, which saves you a nice amount of money in the near term.
Imagine you're in the 24% tax bracket and contribute $5,000 in a single year to a traditional IRA or 401(k). The IRS then can't tax you on that $5,000, which means you save yourself $1,200 in the process, just like that. Not only that, but once you invest the money in your traditional IRA or 401(k), any gains on that account are tax-deferred until you take withdrawals during retirement. This means you don't pay capital gains taxes year after year as with a traditional brokerage account you invest in.
Furthermore, you don't have to limit yourself to a traditional IRA or 401(k). If your earnings don't exceed the eligibility limits, you can fund a Roth IRA, which won't give you an immediate tax break on contributions, but it will give you tax-free growth on your invested savings and tax-free withdrawals during retirement. And if your employer offers a Roth savings option within its 401(k) plan, you can capitalize on that no matter how much money you earn. In that case, the benefits are the same as those of a Roth IRA -- tax-free investment growth and tax-free withdrawals.
Don't give the IRS extra cash
Any money you contribute to or invest in an IRA or 401(k) is money the IRS either can't tax you on, or can't tax your gains on. Currently, you can contribute up to $6,000 a year to an IRA if you're under 50, or $7,000 if you're 50 or older. The annual contribution limits for 401(k)s are much higher -- $19,000 for workers under 50, and $25,000 for those 50 and over. But you don't have to max out either limit to score a sweet tax break, so don't sweat it if you can only afford a few hundred or thousand dollars a year. Once you get into the habit of funding a retirement plan, you may find that it's easier to ramp up your contributions over time. And that's a good way to stop giving your money away needlessly.