With the economy still sluggish, it’s understandable that most of us are still preoccupied with the job market. But just because employment is your main concern, don’t let that keep you from thinking ahead to your retirement. While the key to comfortable retirement is a solid savings plan, tax strategies also play a significant role, so be sure to choose planning tools that will maximize the benefits of tax-deferred and tax-free growth before you retire. Here are some key considerations to help you get started.
Social Security will be there for you at retirement, but in all likelihood it won’t cover all of your living expenses. Most financial advisers say you’ll need to continue receiving 80% of your pre-retirement earnings to comfortably maintain your pre-retirement standard of living. If you have average earnings, your Social Security retirement benefits will replace only about 40% of your pre-retirement earnings, so you’ll need to supplement your benefits with a pension, savings or investments. If you have additional sources of taxable income, you may have to pay taxes on your Social Security benefits. For example, if you earn wages, are self-employed, or receive interest or dividends, you’ll have to report income on your tax return; depending on the income amount, you may need to pay federal taxes of up to 85% on your Social Security benefits.
Setting up an IRA
One good way to start saving for retirement is by setting up an Individual Retirement Account, also called an IRA. This type of retirement plan comes with tax advantages for retirement savings, and can be either set up individually or through an employer. Essentially, IRAs allow you to contribute funds to a retirement account while deferring taxes or avoiding them all together. The two common types of IRAs are:
Traditional IRAs: Under these plans, annual contributions of up to $5,000 ($6,000 for those 50 and older) are tax-deductible. Once your money is within the IRA, any transactions and earnings are not tax-impacted. These funds are ready to be withdrawn at retirement, or at the latest, once you turn 70½. Withdrawals at retirement are taxed as income, but if you withdraw before you retire or turn 59½, you’ll usually have to pay a 10% penalty on top of income tax.
Roth IRAs: These accounts function much like a traditional IRA, except with fewer restrictions. Like a traditional IRA, all transactions within the account have no tax impact, but unlike a traditional account, contributions are not tax deductible but rather are made with after-tax funds. Distributions are not required beginning at age 70½, and you can withdraw contributions after five years without being subject to penalty or tax (though before that five year mark, the interest earned in the account is taxed).
However, there are exceptions to the penalties for early withdrawal. You can use IRA funds for any of the following:
- up to $10,00 to purchase a first home
- to pay for qualified higher education expenses
- to cover medical expenses exceeding 7.5% of your adjusted gross income
- to cover your medical insurance premiums (if you received unemployment compensation for at least 12 consecutive weeks)
- to cover amounts withdrawn due to permanent and total disability.
Take Advantage of the Retirement Savings Contribution Credit
With the Retirement Savings Contribution Credit (or “Saver’s Credit”), you may be able to claim a tax credit of up to $1,000 (up to $2,000 if filing jointly) if you make eligible contributions to an employer-sponsored retirement plan or an IRA. The Saver’s Credit is equal to a percentage of your eligible contributions — 10%, 20% or 50% — as determined by your AGI and filing status. To qualify for the 2010 Saver’s Credit, you must:
- be 18 or older
- not be a full-time student
- not be a dependent on someone else’s return
- not have an AGI that exceeds $55,500 if Married Filing Jointly, $41,625 if Head of Household and $27,750 if Single, Married Filing Separately or Qualifying Widow(er)
Look into 401(k) Plans
401(k) retirement plans are a great way to save for retirement while deferring income taxes on the saved money and earnings until you make withdrawals. Many employers offer 401(k) plans that allow you to contribute a percentage of each paycheck to the plan, and many companies even match up your contributions up to a certain percent. Like IRAs, there are penalties to early withdrawals except in certain hardship cases. Unlike IRAs, you can put away up to $15,500 a year ($20,500 for those over 50, if your plan allows it), though this depends on how much your company allows you to contribute. Because 401(k) contributions reduce your taxable salary, they may pull your adjusted gross income down to a level that permits you to deduct your IRA contributions. Check the IRS table that corresponds to your retirement plan (i.e., covered by your work or not) to find out your deduction amounts.
Rollovers to Roth accounts
Under the Small Business Jobs Act, you can rollover elective deferral plans to Roth-designated accounts. If your 401(k) plan, 403(b) plan or governmental 457(b) plan has a qualified designated Roth contribution program, any distributions made after Sept 27, 2010 to your non-Roth account can be rolled over into the designated Roth plan. This gives you a bit more flexibility with your retirement plans. You must still include the taxable amount of the rollover in your gross income (for rollovers in 2010, include the taxable amount in your gross income half in 2011 and half in 2012).
This is an overview of the tax laws that affect individuals planning for retirement. We’ll be covering more specific areas of tax law changes in future posts, so stay tuned. For more info, check out Rocket Lawyer’s Free Legal Help Personal Tax Articles.