It’s the middle of another tax season, which means 2011 income-earners have looked, are currently looking, or are dread to look at their prepared return and wonder, “Did I deduct everything I could this year?”
If you haven’t taken steps toward planning for retirement, the simple answer is no. Certain retirement funds—namely, Individual Retirement Arrangements and company 401(k) plans—can reduce your present day taxable income, shrinking your tax bill or engorging your refund. And its not too late to benefit for your 2011 return: a traditional IRA allows you to contribute through the federal filing deadline.
Individual Retirement Arrangements
IRAs were conceived in 1974, when Congress enacted the Employee Retirement Income Security Act. They were originally restricted to workers not covered by a employer’s retirement plan, but in 1981 the Economic Recovery Tax Act opened the option to any and all wage-earners below the age of 70 years and six months.
Every IRA can be funded only by cash and cash-equivalents such as financial securities. When real estate investment is offered, any revenues generated cannot provide an immediate financial benefit to the IRA-holder.
IRAs come in two popular flavors: the aforementioned traditional IRA, and the Roth IRA. To easily illustrate the difference between them, they can be thought of as instant tax gratification and delayed gratification IRAs, respectively.
A traditional IRA is funded by pre-tax dollars. That means contributions to your retirement account can be deducted from your taxable income, reducing what you owe. The trade-off is that withdrawals from the retirement account will be taxed as income in the future.
The reverse is true of Roth IRAs, introduced in 1997 and named for Senator William V. Roth, Jr. Contributions to a Roth IRA are made with after-tax cash-equivalent assets, but are completely tax-free when withdrawn at retirement.
Other IRA variations include:
• Simplified Employee Pension IRA: an employer makes retirement plan contributions on behalf of his employee (or, in the case of a self-employed individual, himself), in the employee’s name. Introduced as an alternative to pension plans for which the employer was financially liable.
• Savings Incentive Match Plan for Employees (SIMPLE) IRA: For every contribution to this plan made by an employee, the employer must match it up to the annual contribution limit.
• Self-Directed IRA: Whereas the holder of another IRA might direct his financial institution to make certain investments with IRA funds, the self-directed IRA makes its holder directly responsible for all investments.
Through 2012, contributions to IRAs are limited to $5,000 per year for persons less than 50-years-old, and $6,000 for workers older than 50, according to the Internal Revenue Service. Contributions are restricted to earned income. If you earn only $3,500 in a given year, you cannot contribute more than that amount; not even from your savings.
Contribution limits have risen in the past to adjust for inflation—the original limit was $1,500—and may continue to rise.
An IRA can be opened with your local bank, a life insurance company, a mutual fund, or stockbroker.
A word of caution: carefully research any IRA investments any financial institution offers; high-risk ventures, while seductive, run counter to the slow-and-steady principles of retirement investments. Any institution that offers “IRS-approved” investments carries a big red flag: the IRS released a public service announcement in 2009 warning taxpayers that the IRS does not approve any investments, regardless of their veracity.
The Securities and Exchange Commission offers its own advice for picking investments.
401(k) plans: immediate tax benefits and tax deferred growth
Employer-based 401(k) retirement portfolios are similar to traditional IRAs in the sense that taxes on retirement funds are deferred to future withdrawals. But a 401(k) offers a greater annual contribution limit of $15,500 and—because contributions are deducted from your paycheck—what you pay into the plan immediately reduces your taxable income.
If you are in a 25 percent tax bracket and contributed $100 in a given paycheck, you saved $25 in taxes and only effectively paid $75 to participate in the plan for that pay period.
There are no income limitations to receive the tax credit on a 401(k), and some employers offer matching contributions.
401(k) holders must begin withdrawing funds the year after they turn 70 years and six months old.
Ask your employer if they offer a 401(k) plan and what it entails.
