Contributing to a qualified retirement account is the one way to save on taxes with double benefits. This tax savings method reduces your immediate tax liability, while putting away tax-deferred savings for your future. Tax deferred savings plans have the advantage of growing in value by adding interest, dividends, or capital gains over the years. These gains are not subject to any tax until the money is withdrawn at which time you may be in a lower tax bracket.
Retirement Plans. There are many types of retirement plans that qualify. If you or your spouse is offered a 401(k) or similar retirement plan from your employer, it makes sense to put as much in the plan as is allowed or at least as much as you can afford. This type of plan has the advantage of not only saving you income taxes on the money you contribute, but the employer often makes additional contributions that add to your savings with no taxes of any kind for the tax year in which they are contributed. Maximum contributions to these plans vary by the type of plan and your employment situation. Contact your human resources department for more information.
IRAs. If you or your spouse’s employer does not offer a retirement plan, you may be able to purchase an individual IRA, which has the same effect. The amounts of the contributions are subtracted from your taxable income and the plan is not subject to tax until the money is withdrawn. The contribution limit on these plans for 2015 is $5,500 per individual and you may add an additional $1,000 catch up amount if you are over age 50.
Simplified Employee Pensions. There are even more options for self employed individuals. You can invest in an individual IRA as described above with the same limitations. However, if your net income is in excess of $35,000 per year you are subject to self-employment tax (Social Security, Medicare). A better option for you would be the Simplified Employee Pension (SEP). The contribution limits on a SEP are 25% of compensation or, more realistically, 20% of income subject to self employment tax. The maximum contribution for this type of plan is $50,000 for incomes up to $250,000. For example, if your net income from the Schedule C of your business is $50,000, you can put $10,000 in a SEP. If you are in the 25% tax bracket (more than $36,000 taxable income for single filers or $71,000 for married filing joint) your tax saving is $2,500. The advantage of an individual IRA or a SEP is that you do not need to make the contributions in the current tax year. The plans may be set up and the contributions made as late as April 15th of the following year for an IRA or by the extended deadline for tax filing for a SEP.
If you are interested in setting up either an IRA or a SEP, you should contact a bank, investment firm or other financial institution to learn about their investment options, costs and other limitations. You can call ATBS for any discussions of tax implications for your specific situation.
Business Structures. If you own a corporation or LLC, have employees, or earn a much larger income than discussed above, there are other options available. They are more complicated to setup and have more rules, but do allow for better tax advantages in some cases. Please contact us or your financial institution if you would like more information in this area.
All of the plans discussed above have the advantage of reducing your tax liability in the plan year, but are subject to tax, and possible penalties, when the funds are withdrawn. The penalties apply to withdrawals made before the owner is age 59.5 with a few exceptions. There are other rules involving withdrawals but for the most part, they are only subject to your individual tax rate at the time the money is received.
Roth. If you would prefer to have retirement income not subject to tax there is a Roth option for almost all of these plans. The contributions to a Roth are not deductible from taxable income in the year contributed, but all withdrawals made after age 59.5 are not subject to any form of income tax.
The tax implications discussed in this article refer to taxes only at the federal level. Each state has its own tax rules involving retirement accounts and income. You should consider your state’s rules in any decisions you make in this area.