How Retirement Accounts Save Money on Taxes
Find out how traditional and Roth retirement accounts help you pay less tax and accumulate more wealth for retirement.
If you’re a regular Money Girl reader or podcast listener, you know that I recommend investing through tax-advantaged accounts—like an IRA or a workplace 401(k)—to build your retirement nest egg.
But how do retirement accounts actually help you save money on taxes? This was a common question I recently received at a financial seminar that I presented to a large company in New York City.
In this episode I’ll cut through the confusion and explain terms like “tax-deferred” and “tax-free.” You’ll find out how traditional and Roth retirement accounts allow you to pay less tax and accumulate more wealth to spend in retirement.
Plus, I’ll finish by answering a listener question about whether moving to a different state in retirement could affect the tax you have to pay when taking money out of retirement accounts.
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See also: How Much Money Do You Need to Retire?
Since taxes take a big bite out of income, it’s smart to cut them every way legally possible. Fortunately, we get a nice tax break for something that we should be doing anyway—saving for retirement.
Retirement accounts can cut your taxes in 2 main ways: tax-deductible contributions and tax-free withdrawals.
How Tax-Deductible Retirement Contributions Save Money
Contributions you make to a traditional retirement account—such as a traditional 401(k) or an IRA—are tax-deductible. In other words, you make them on a pre-tax basis.
Workplace plans deduct contributions directly from your paycheck before taxes are taken out. Or if you make IRA contributions with after-tax money, you get to claim a deduction for those amounts when you file your taxes.
For instance, if you earn $50,000 and contribute $5,000 to a traditional IRA or 401(k), you only have to pay tax on $45,000 that year. Avoiding tax on $5,000 of income could save about $850, depending on your situation and the state where you live.
Reducing the amount of income you have to pay tax on is a smart way to keep more of your money and pay less to the government.
Annual contribution limits for retirement accounts are established each year by the Internal Revenue Service. For 2014, you can contribute up to the following amounts to an IRA or workplace plan:
- IRA (under age 50) – $5,500
- IRA (age 50 or older) – $6,500
- 401(k), 403(b), or 457 plan (under age 50) – $17,500
- 401(k), 403(b), or 457 plan (age 50 or older) – $23,000
Plus, employers can add additional funds, such as matching or discretionary contributions, to your account, which allow you to exceed these annual limits.
However, with a traditional retirement account, the tax man catches up to you eventually. Any amount you withdraw is subject to ordinary income tax, plus a 10% early withdrawal penalty if you’re younger than age 59½.
Distributions are added to your total income for the year. You must pay ordinary tax—but not capital gains—based on your income tax bracket at the time you withdraw traditional funds, no matter if the money comes from your original contributions or their earnings.
See also: 6 Retirement Accounts You Should Know About (Part 1)
Traditional retirement accounts are known as tax-deferred accounts because you delay all taxation until you take distributions in the future.
How Tax-Free Withdrawals from Retirement Accounts Save Money
In addition to traditional accounts, there’s another type of retirement account called a Roth. These flip-flop taxation from a traditional account because contributions to a Roth are not tax-deductible, which means you must pay tax on them upfront.
A Roth allows you to avoid paying one penny of tax on growth in the account that may have accumulated over decades.
For instance, if you earn $50,000 and contribute $5,000 to a Roth IRA or Roth 401(k), you must pay tax on $50,000 that year. There’s no immediate tax benefit for Roth contributions.
However, the great feature of a Roth is that future withdrawals that you make after age 59½ are completely tax-free (unlike with a traditional account). A Roth allows you to avoid paying one penny of tax on growth in the account that may have accumulated over decades.
You can even withdraw your original contributions tax-free before reaching age 59½, if you’ve owned a Roth account for at least 5 years. But withdrawing any amount of earnings from a Roth IRA or workplace plan triggers a 10% early withdrawal penalty.
Let’s say you put $5,000 a year into a Roth IRA for 30 years, which is a total of $150,000 in contributions. If that amount mushrooms to a value of $450,000, you’d avoid tax on the difference, or $300,000 of earnings. Depending on your situation, that might give you a tax savings of $60,000!
See also: Should You Have a Traditional or Roth IRA?
As long as your money stays in a traditional or Roth retirement account, you won’t pay any tax on investment earnings. They get reinvested and compound year after year without any federal or state tax bill.
As I previously mentioned, you’ll never get a tax bill from a Roth account when you withdraw money in retirement, but you will for traditional accounts.
Do States Tax Retirement Accounts Differently?
A listener named Paul asks:
“I have traditional and Roth retirement accounts and have been contributing to them in Texas, where there is no state income tax. If I decide to retire to a different state that does have income tax, would I have to pay it on my retirement distributions?”
The good news is that no matter where you live, you won’t have to pay any federal or state tax on Roth distributions. However your traditional account withdrawals will be subject to both federal and state income tax depending on where you live during retirement.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
