Building up retirement while you are trying to also make an income can be daunting. If you can reduce the amount of income taxes you have to pay at this time, you can reduce the financial crunch of saving, investing, and living expenses.
Start With Your 401(k)
A 401(k) is an employer-sponsored retirement account that gives you the chance to invest pre tax dollars in the markets. For W2 employees, pretax income refers to the total amount of your wages before deductions.
Your 401(k) investments are drawn out before your pretax income gets counted or calculated, so you can lower your taxable income and grow retirement savings. If your employer offers a match, you can also get free money.
Over the course of your lifetime, the accepted understanding is that your income after retirement will be lower than your income during your working life.
By getting money taken out of your gross income and getting your taxes calculated after your retirement dollars get pulled, you can lower your tax payments over the course of your lifetime.
Start a Traditional IRA
According to the experts at SoFi, you can open an IRA for very little money and invest in a wide variety of funds. You will be limited to $6,000 per year, or $500 a month if you prefer.
A traditional IRA gives you a tax break now. You can deduct your traditional IRA contributions off of your gross income level.
However, if you have both an IRA and a 401(k), you will need to watch the contribution limits to avoid a penalty. Your age will have a big impact on these limits, and tax law changes may also increase your options.
Consider a Roth IRA
A Roth IRA is funded with post-tax dollars now to save you tax dollars later. Additionally, a Roth IRA can be set up for a non-earning spouse. If your spouse has been home caring for children or for any other reason, they can still have retirement savings if you set up a Roth for their benefit.
Because both a Roth and a traditional IRA have contribution limits, you may be tempted to set up multiple retirement accounts.
Avoid Penalties and Taxes
If you need to take cash out of any of these retirement funds before you turn 59 and a half, you will nearly always face a penalty. Additionally, you will have to pay income taxes on this withdrawal.
Make sure that your retirement contributions do not put the monies out of reach that you may need to access quickly. In the event of a hardship withdrawal, you may be able to avoid the penalties, but do make sure that your emergency savings accounts are fully funded before you open multiple retirement accounts.
In short, your 401(k) and traditional IRA will save you tax dollars now by reducing your taxable income, but the money and the investment proceeds will be taxable when you withdraw it. A Roth IRA will need to be funded by post-tax dollars, but you will not have to pay taxes on the withdrawals. Click here for “Retiring abroad and US tax“.