Planning for retirement is one of the smartest financial moves you can make. However, contributing to a retirement account doesn’t just set you up for the future; it also gives you some serious tax advantages today. Whether prepping for retirement yourself or running a business that offers plans to your employees, understanding the tax perks that come with retirement contributions can help sharpen your financial strategy. Continue below to learn more.
Explore The Different Types of Retirement Accounts
There are several retirement accounts that offer tax benefits, each with its own set of rules and advantages. Below, we’ll break down the most common ones:
Traditional IRA (Individual Retirement Account)
Contributions to a Traditional IRA are tax-deductible, which means they lower your taxable income for the year. Plus, the money in the account grows tax-deferred, meaning you don’t pay taxes on any gains until you start withdrawing the funds in retirement. The idea is to delay taxes until you’re in a lower tax bracket.
Roth IRA
Unlike a Traditional IRA, Roth IRA contributions are made with after-tax dollars. You won’t get an immediate tax break, but the upside comes later — when you start withdrawing funds in retirement, all the money, including gains, is tax-free. That’s a huge win if you expect to be in a higher tax bracket down the road.
401(k) Plan
Many employers offer 401(k) plans, where you can contribute pre-tax income, reducing your annual taxable income. The money grows tax-deferred, and like the Traditional IRA, you’ll only pay taxes when you start withdrawing it in retirement. The bonus here? Some employers match your contributions, which is essentially free money for your retirement.
SEP IRA (Simplified Employee Pension)
This one’s for the small business owners and self-employed folks. Contributions to a SEP IRA are tax-deductible, and the funds grow tax-deferred. The best part? You can contribute more than you can to a traditional IRA, which is perfect if you want to boost your retirement savings quickly.
Solo 401(k)
If you’re self-employed and don’t have employees, a Solo 401(k) is a solid option. You get to contribute both as an employee and an employer, allowing you to sock away even more money. Plus, contributions reduce your taxable income; like the other plans, your money grows tax-deferred.
Key Tax Benefits of Retirement Contributions
1. Lowering Your Taxable Income: The most immediate benefit of contributing to tax-deferred retirement accounts, like a 401(k) or Traditional IRA, is that your contributions reduce your taxable income. For example, if you earn $75,000 a year and contribute $6,500 to a Traditional IRA, your taxable income drops to $68,500. This could even knock you into a lower tax bracket, cutting your overall tax bill.
2. Tax-Deferred Growth: When you stash money in a Traditional IRA or 401(k), you don’t pay yearly taxes on your investment gains. Instead, those gains grow tax-deferred, meaning you only pay taxes when you withdraw the money in retirement. This lets your savings compound faster since you’re not being hit with taxes on the gains every year.
3. Roth IRA: Tax-Free Withdrawals: While Roth IRAs don’t give you an upfront tax break, the real benefit comes later — withdrawals are 100% tax-free in retirement. That’s a huge win if you think taxes will be higher in the future or if your income will be higher in retirement.
4. Employer Matching Contributions: If you’re contributing to a 401(k), there’s a good chance your employer will match a portion of your contributions. That’s free money going straight into your retirement account. And even better, employer contributions aren’t included in your taxable income for the year, which means you get more savings without paying extra taxes.
5. Self-Employed? Higher Contribution Limits: If you’re self-employed, retirement plans like the SEP IRA or Solo 401(k) let you contribute much more than traditional retirement accounts. For 2024, you can contribute up to 25% of your net self-employment earnings or $66,000 (whichever is lower) with a SEP IRA. That’s a lot of tax-deferred savings.
Maximize Your Tax Benefits
To make the most of the tax benefits from your retirement contributions:
- Contribute the Maximum Amount: Each retirement account has a contribution limit. In 2024, Traditional and Roth IRAs allow contributions of up to $6,500 (or $7,500 if you’re 50 or older). The 401(k) contribution limit is $23,000, with an extra $7,500 for those 50 and up. Contribute the max if you can — it’ll give you the biggest tax savings and beef up your retirement fund.
- Catch-Up Contributions: If you’re 50 or older, you can make catch-up contributions, which means you can contribute more than the usual limit. This helps reduce your taxable income even more and accelerates your savings.
- Diversify Your Accounts: You don’t have to choose just one type of retirement account. If possible, contribute to both a tax-deferred account (like a 401(k)) and a Roth IRA. This way, you’ll get immediate tax savings now and tax-free withdrawals later.
Get Further Guidance from the Charleston CPA Team at Draffin Tucker
Retirement contributions aren’t just about your future — they’re also about saving you money on taxes right now. Whether you’re using a Traditional IRA, a Roth IRA, or a 401(k), these accounts offer real advantages. Lower your taxable income, let your investments grow without tax interference, and set yourself up for a tax-friendly retirement. If you’re self-employed, the perks can be even bigger.
Not sure which retirement plan works best for you? Or how to maximize the tax benefits? The tax services at Draffin Tucker can help you build a strategy that suits your goals. Get in touch with our accounting services team, and let an experienced tax professional ensure your retirement plan works as hard as you do.