Well, we are truly on the final day of 2020. As if you didn’t already have enough places to figure out where your money needs to reach, there’s another consideration—your retirement account contributions.
“But retirement is so far away!”
The only person who can get away with saying retirement is far away is a 16-year old. Anyone older should be doing at least a little saving for their future. If you hope to retire one day (we all do, right?), you’ll need to be doing some planning and saving.
You might be wondering what the rules are when it comes to certain accounts. Start by learning what retirement accounts you should contribute to before the year is over.
This is one of the more popular places to save for retirement for many Americans. The 401k and 403b are employer-sponsored retirement plans. This means your employer set up the plan, and a third party manages the account.
The main difference between the two is that a for-profit company sets up a 401k, and a non-profit or government organization sets up a 403b. Examples of people who might have a 403b are teachers, people who work in hospitals, and government workers.
If you work for a business whose purpose is to create profit, you will see a 401k. The employers will abide by different tax rules, but the tax rules on these two accounts are the same for the employee who holds the account.
You like paying less in taxes. Any contributions or money that you put into your 401k or 403b gives you a direct tax benefit in the year of your contribution. Money put inside these accounts gets deducted from your income when you file your taxes.
Shrinking your taxable income will lower your taxes owed because you are responsible for paying taxes on a smaller amount of money.
Say you make $50,000 in a year. You contribute $400 a month to your company 401k. At the end of the year, your contributions total $4,800. When you file your taxes, that $4,800 will be deducted from your income.
Now you are only responsible for owing taxes on $45,200. There are other things to consider and other deductions that will further lower your taxable income, but retirement account contributions are one of the easiest ways to reduce your taxes.
The money inside your retirement account now has the ability to be invested! Those investments are allowed to grow, tax-deferred. That means you don’t have to worry about paying any capital gains on sales inside the account. You will only be responsible for paying income tax on withdrawals from the account, hopefully after age 59.5.
This is a retirement account, so there are some rules for technically accessing your savings. The current rule says you have to be age 59.5 before taking withdrawals from your IRA’s, without penalty. Taking money out before that could result in a 10% penalty, on top of the income tax owed on withdrawal.
There are certain circumstances where the penalty isn’t applied, including a new one put into place this year, which took away the penalty for early withdrawals due to COVID. If you plan to access your retirement savings early, make sure you know how it will be taxed and if it will be penalized.
Unlike Individual Retirement Accounts (IRA’s), the 401k and 403b normally need to be funded by the end of the year. This is important to note if you are currently using one of these accounts to save for retirement. If you have contributions coming directly out of your paycheck, you might want to adjust your contribution amount for the final month to maximize your tax savings for 2020.
A great goal when it comes to saving for retirement is 10% of your income. Depending on what stage of life you’re in and how much you make, 10% might seem daunting. If you are just starting out and money feels tight, you can start with a smaller percentage.
One great tip for starting small is to increase your contributions by 1% every year. For example, you might start by saving 5% of your paycheck this year. Next year, you would increase your contribution to 6%, then 7% the following year.
Could your retirement account benefit from a 1% increase this month? And how might that small increase impact your bottom line come retirement time? Part of the magic with these small changes is that we will hardly notice the difference in our checking accounts. Let compounding interest take over, and the effects are anything but small!
You might be ready to throw as much money as you can into your retirement account, but there are some rules there. Including an annual limit for how much money you can contribute in a given year.
For 2020, the annual contribution limit to 401k’s and 403b’s is $19,500.
For those over age 50, there is an additional $6,500 “catch-up” contribution, bringing the annual limit to $26,000.
Employers might also be contributing to your account, known as an “employer match.” If your employer is offering a match, try to contribute enough to get the full match. Employer matches are essentially free money in your account, which you don’t want to leave on the table.
The annual total for both employee and employer contributions into a 401k or 403b is $57,000. (Yeah, you might need to remind your employer about that).
The retirement account contribution limit does not increase for employees in 2021. The limit remains at $19,500 or $26,000 if over 50. However, there is an increase in the employer side, bringing the total of employee plus employer contributions to $58,000.
How far are you from maxing out your 401k or 403b? This might be a good time to set some savings goals for next year and try to get closer to the max if you aren’t already there.
There are many Americans that don’t have access to a 401k or 403b through an employer. They are not a requirement for employers to provide, and many small businesses find the cost of setting up and maintaining them is too high. If you are self-employed, you will also find yourself in a position without access to one of these accounts.
If you find yourself without a 401k, you might be asking, “How am I you supposed to save for my future?“
401k’s and 403b’s are not the only retirement accounts out there! There are various Individual Retirement Accounts (IRA’s) available. You don’t need an employer to open these accounts; the only requirement is having earned income.
IRA stands for Individual Retirement Account, and this is another great place to save for retirement. If you don’t have access to a 401k or 403b, you will definitely want to utilize an IRA. There are quite a few different kinds, including the traditional IRA, Roth IRA, SEP IRA, and SIMPLE IRA.
Any contributions to a traditional IRA, SEP IRA, or SIMPLE IRA will be tax-deductible in the same way a 401k or 403b is. You see the tax benefit of lowering your taxable income the year of the contribution, and you will also see the same tax benefits of tax-deferred growth.
Trading in your IRA also won’t incur capital gains taxes throughout the year.
When will you have to pay taxes? When you make withdrawals and pull the money out. To avoid the extra 10% penalty, withdrawals should be planned for retirement and after age 59.5.
This retirement account has a whole different set of tax rules, but some can prove very beneficial in the future. Unlike the other accounts we talked about, contributions to your Roth IRA are NOT deducted from your income! Does that mean you don’t see any tax-savings? Not quite.
Since you are NOT deducting Roth contributions, you agree to pay taxes (or have already paid taxes) on the money you put in. Your money is taxed at today’s known tax rates. When you pull your money out in retirement, it will NOT be taxed again.
You will be paying taxes eventually on the money inside your 401k, 403b Traditional, or SEP IRA’s, but you are paying taxes now instead of later with the Roth. Why would you want to do that? We are in historically low tax brackets currently.
People who find themselves in lower tax brackets, like 10% and 12%, can lock in these low tax rates with Roth contributions.
There are certain limitations to Roth IRA’s, one of them being an income limit. If you make too much, you will not be able to fund a Roth IRA directly, so make sure you qualify before making contributions.
You open an IRA with a custodian. Opening one is just as easy as opening a checking or savings account. Custodians offer the ability to place trades in the stock market (and in bonds and various commodities) with your cash and provide a safe, insured place for you to keep your investments.
You can link your checking or savings account to your investment account and quickly move money into it. To replace contributions coming out of your paycheck, like for a 401k or 403b, you can set up automatic deposits to take place every month or two weeks. Be sure to invest that money.
Retirement account contributions to your IRA have a different deadline than 401k and 403b contributions. All annual contributions have the same deadline, Tax Day, which is normally April 15th. If the 15th is a weekend, it will be the following Monday.
This deadline gives you a little more time and flexibility for making contributions. Although you have until Tax Day, remember, a big point of these contributions is getting the tax savings.
If you file your taxes in February and contribute to your traditional IRA for 2020 in March, you will want to amend your taxes to account for the difference. Want to get your taxes done early? And don’t want to file an amendment? You should make all IRA contributions before you go to file your taxes.
When you are making contributions to your IRA in 2021, there will be a selection where you can select if the contribution is for 2020 or 2021. However, you are the one responsible for reporting your contributions on your taxes. If you are not deducting your contributions, you don’t see any tax savings.
You are responsible for paying income taxes on your IRA withdrawals in retirement (minus the Roth), so not getting the tax deduction today means you are paying double taxes on that money. You do not want that.
The 2020 annual contribution limit for the traditional and Roth IRA is $6,000. If you are over age 50, the limit increases to $7,000. These limits are much lower than the 401k and 403b limits, which are $19,500 and $26,000 if over age 50.
This $6,000 (or $7,000) limit is for the Traditional and Roth combined. Not each. You could potentially put $3,000 into a Roth IRA and $3,000 into a Traditional IRA, or any variation that adds up to a combined total of $6,000. Or you could put the full amount into just one of these IRAs. The choice is yours, as long as they don’t go over the limit.
Want to fund a 401k and an IRA? Be aware of any limitations. Your earnings can impact how much you can deduct from IRA contributions. Make sure you understand the rules and limitations when you are funding these accounts.
Most IRAs did not see an increase in the contribution limit for 2021. It’s not normal for them to increase every year, but they regularly get increased to keep up with cost-of-living.
The places that did see an increase were the employer sides. Employers can contribute up to $1,000 more, bringing the total of employee contributions ($19,500/$26,000 if over age 50) plus employer contributions to $58,000 for 2021, previously $57,000.
This increase also applies to self-employed individual retirement accounts. Limits for the SEP-IRA also go up to $58,000 in 2021 (limited to 25% of your self-employment income). SIMPLE IRA’s remain the same at a limit of $13,500.
Once you understand what accounts can be used to save for retirement and their deadlines, the only thing left is to keep up with your retirement contributions. The easiest way to save for retirement is to automate your process as much as possible.
Getting 401k or 403b contributions taken directly from your paycheck is a great way to make sure you are saving consistently.
For IRAs, you will want to manually set up automatic deposits, and if possible, automatic investing.
The worst thing you can do? Ignore saving for your future. Investing on your own has never been easier, and there are too many great tax perks on retirement accounts to pass up.
Take advantage of the time you have and the magic of compounding interest that is possible inside your retirement accounts. Retirement is a lot more expensive than many people think; make sure you save for this imminent life phase.
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