Now that tax season is officially underway, millions of working Americans will soon start gathering paperwork and reading up on ways to shield their income from the IRS. And there are plenty of valuable tax credits and deductions that can help you accomplish the latter. But if your goal is to save money on taxes, perhaps the single best way to get there is to make the one move that will also set you up for a financially secure future: contribute to a traditional retirement savings plan.
How traditional IRAs and 401(k)s work
IRAs and 401(k)s come in two main varieties: traditional and Roth. With a traditional IRA or 401(k), funds go in on a pre-tax basis, grow tax-deferred, and are only taxed once removed. With a Roth, funds go in on an after-tax basis, but then grow tax-free, and withdrawals are tax-free as well.
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Now to be clear, there are plenty of good reasons to save in a Roth account -- namely, you get more flexibility with your money in retirement. But if your goal is to lower your near-term tax burden, then a traditional IRA or 401(k) is the way to go.
What tax savings can you reap from a traditional retirement plan?
Traditional IRAs currently max out at $6,000 in annual contributions for workers under 50, and $7,000 for those 50 and over. Meanwhile, 401(k)s have a much higher annual contribution limit: $19,500 for workers under 50, and $26,000 for those 50 or older.
Whether you're able to hit the annual max or only contribute a fraction of it, the funds you put into a traditional IRA or 401(k) represent income the IRS can't tax you on. You actual savings, however, relate to the tax bracket you fall into.
Your tax bracket represents the tax rate you pay on your highest dollars of earnings, and so it can differ from year to year based on your income, or based on IRS changes. Now, let's imagine you're 40 years old, you're single, and you manage to max out your IRA this year at $6,000. Let's also assume your income is $100,000, which puts you in the 24% tax bracket. As such, that $6,000 contribution gives you $1,440 in tax savings, because you'd otherwise be subject to a rate of 24% on those earnings. And that's what makes traditional retirement plans so valuable.
You need money for the future
Of course, the other benefit of saving in a traditional retirement plan is giving yourself access to future funds that you'll need when you're older. Once you stop working, you'll need income outside of Social Security to pay your living expenses, so the more money you put into a retirement plan while you're able to, the less financial stress you'll grapple with later in life.
This year, as you sit down to work on your taxes, don't just tally up your housing expenses or charitable donations to see what sort of tax break they give you; see if you're on track to fund your IRA or 401(k) to the greatest extent you're capable of -- and if not, ramp up. Doing so will not only shield a potentially large chunk of your income from the IRS, but it will also help ensure that you're able to live comfortably when you're older.
