It’s never too early to start planning for retirement. After all, most of us need up to 80% of our current annual income to retire comfortably. One way to maximize your future savings is by deferring your tax liability until you’re ready to retire.
In this blog, we’ll outline the best ways to go about deferred tax planning, to ensure that your retirement savings work for you, and not the other way around.
Retirement Savings are Important for Tax Planning
Retirement plans offer a number of benefits. Firstly, they’re a great way to ensure adequate savings for when you stop working. But there are also several tax advantages. In a nutshell, they help you reduce your current taxable income. And if you’re a business owner with staff on your payroll, they provide the same advantage to your employees.
Contributions to qualified accounts, like 401(k)s, traditional IRAs, and 403(b)s (if you work for or own a nonprofit), are often tax-deductible. This means they lower your taxable income for the year in which you make contributions. But even better is the fact that these kinds of retirement plans allow for tax-deferred growth. In other words, you don’t pay taxes on the earnings until you withdraw them. That way, you can save now, and help your investments grow over time.
Essentially, making regular contributions to a retirement plan lowers your adjusted gross income (AGI). This directly reduces your tax liability, or the amount of your income that’s taxed in a year. This is a great help if you want to lower your tax bracket, or the amount of taxable income subject to other taxes like Medicare or Social Security.
The Different Types of Retirement Savings Plans
There are several kinds of plans you could consider for effective deferred tax planning retirement savings.
401(k) plans
These are popular employer-sponsored plans. Basically, they let you contribute a portion of your paycheck to a retirement account. These payments are made pre-tax, so you don’t pay federal income taxes on them until you make a withdrawal when you retire.
And if you’re an employer, you can make matching contributions, in which you also add money to your staff’s plans, up to a certain percentage. These matching payments are also not taxed when they’re made.
The money you invest in these plans grows tax-deferred, meaning that compound interest accumulates, without the burden of annual taxes. This year, it’s possible to contribute a maximum of $22,500 a year to a 401(k), unless you’re older than 50. In this instance, you can make catch-up contributions of up to $30,000 a year.
Note that both employee and employer contributions are taxed when you withdraw your funds, along with any investment gains. And if you make that withdrawal before age 59½, you might be subject to a 10% early withdrawal penalty on top of these taxes.
SIMPLE IRAs
The Savings Incentive Match Plan for Employees (SIMPLE IRA) was created for small businesses, with up to 100 employees. As with 401(k)s, both workers and their employers can contribute to these retirement savings plans.
In 2024, you can pay up to $15,500 (or $19,500 in catch-up contributions). If you’re the owner of a small business, you have two options. You can either match your employee contributions, to a value of 3% of their annual compensation, or give a non-elective contribution of 2% of each employee’s salary, even if they don’t make any contributions.
Payments to your own SIMPLE IRA are also pre-tax. So just like 401(k)s, they lower your current taxable income and grow tax-deferred until you retire. At this point, they’re taxed according to normal income tax rates for your tax bracket. Also, if you make withdrawals before age 59½, don’t forget about the 10% penalty. Note, too, that if you make a withdrawal within the first two years of setting up your SIMPLE IRA, you’ll pay a 25% penalty fee!
SEP IRAs
A Simplified Employee Pension (SEP IRA) is great if you’re self-employed, and is also used by many small businesses. With these retirement savings plans, you’ll only make contributions if you’re the employer, based on a percentage of what your staff is paid, of up to 25% or $66,000. Unlike the other plans we’ve mentioned, SEP IRAs are pretty flexible – you don’t have to make contributions every year, which helps if your business income fluctuates.
Even without annual contributions, SEP IRAs can still reduce your tax burden as a business owner. You see, they’re tax deductible for you as an employer (or as a self-employed person). And to help your staff, the contributions you make grow tax-deferred until they are withdrawn. Just remember that if you’re an employee or self-employed, you’ll be penalized 10% for early withdrawals.
The retirement savings plans mentioned above can help you lower your taxable income. But with a few extra tips, you can ensure you’re saving as much as possible.
Maximizing Contributions to Reduce Taxable Income
There are two ways to ensure you’re making the most of your retirement savings. These are through employer contributions, and employee contributions.
Employer contributions
According to the IRS, there are two types of contributions you can make as an employer. One way is through matching contributions for staff who contribute elective deferrals. These can either be mandatory or discretionary. Alternatively, you can make other contributions, on behalf of all employees who are plan participants. This includes any employees who choose not to contribute elective deferrals.
This means that as an employer, you match a percentage of your worker’s contributions, up to a specific limit. Basically, this gives your employee “free money” to add to their retirement savings. But you also benefit – these contributions are considered tax-deductible business expenses, and lower your company’s taxable income.
Employee contributions
If you’re an employee, retirement contributions lower your taxable income by the amount paid. So, the more you pay into your retirement savings, the less you’re taxed (until withdrawal). An added benefit of this is that significant payments can also help you lower your tax bracket, meaning the rate of tax you pay on your remaining income can be lower.
Also, with a reduced AGI, you may be eligible for tax credits or deductions that have income thresholds.
If your employer is matching your contributions, there are several ways to maximize the benefits. These include contributing enough to get the full employer match. Remember that most employers match a percentage of contributions, up to a plan’s prescribed limits. So if you’re not contributing to the plan your boss has in place, you could be missing out.
Also double-check whether the plan you’re on is subject to a vesting schedule. This means you’ll have to stay at the company for a certain number of years before you fully own the contributions – leaving before then can cost you, literally!
Long-Term Tax Planning Considerations
As we’ve mentioned, your contributions are tax-free, and so are any investment earnings within the account, like capital gains, dividends, and interest, allowing you to effectively re-invest any gains, rather than being taxed every year. That way, you can easily increase the total value of your retirement account.
However, any withdrawals you make – including gains – will be taxed. And the larger the amount you withdraw, the more tax you’ll pay.
For that reason, it’s important to make the most of these returns. And there are a few ways to do that, such as:
- Investment diversification: A portfolio that includes bonds, stocks, and other asset classes can help maximize returns while managing risk.
- A focus on tax-efficient assets: Try to keep high-growth or high-dividend-producing assets in tax-deferred accounts to make the most of these.
- Take advantage of compounding: Start contributing to retirement savings early and regularly. That way, there’s more time for your investments to compound, for higher potential returns.
Retirement Income Planning
While deferred tax planning for retirement savings means you save money now, it’s not a way of avoiding taxes altogether. Remember that all distributions from tax-deferred retirement accounts are treated as ordinary income. This means they’re taxed according to your income tax rate at the time of withdrawal.
Also, as per the SECURE Act 2.0, distributions must begin once you turn 73 years old. As such, there’s a risk of retirement savings pushing you into a higher tax bracket. And this means a higher tax burden.
To mitigate this risk, you need an effective plan for handling your retirement income. For instance, you could consider slowly converting portions of your retirement savings into a ROTH IRA. Unlike traditional IRAs, in these accounts, your contributions are taxed, while withdrawals are not. This means less tax on your IRA payout, and tax-free income from your ROTH IRA.
Another option is to time your withdrawal properly. If you start by drawing funds from taxable accounts, you’ll lower your taxable income in early retirement while your tax-deferred accounts continue to grow.
While we’re on the subject of planning, let’s tackle reporting and compliance requirements.
Compliance and Reporting Requirements
As we’ve already mentioned, each of the retirement savings plans discussed above has specific contribution limits set by the IRS. But there are also deadlines to follow. For most retirement accounts, this is the tax filing deadline of the following year. Although for employer-sponsored plans like 401(k)s, this is usually a year-end deadline.
Not sticking to contribution limits as an employer or employee, or missing these deadlines, can result in penalties.
When you’re filing your taxes, you must report retirement contributions accurately, the right forms. Not doing so can lead to penalties, or missing out on valuable deductions.
To avoid these issues, keep up to date with tax laws and regulations. It’s also crucial to have flexible tax strategies that can be adapted to accommodate any potential changes. And this is where a pro comes in. Tax planning experts like the team at Fusion CPA can help you navigate deferred retirement savings, as well as changing laws and regulations that come with them.
To make the most of the potential benefits of retirement savings, and minimize the risk of penalties, schedule a Discovery Call with one of our CPAs today.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
