Here’s the Smartest Tax Move You Can Make in 2018
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There are plenty of tax deductions Americans can take advantage of, at least until a tax-reform bill passes. Many of these are quite lucrative. Just to name a few examples, the mortgage-interest deduction, charitable-contributions deduction, and state and local tax deduction are worth thousands of dollars each to many taxpayers.
However, there is one tax break that is even better than all of these because it’s a tax break not for money that you’ve spent or donated but rather for money that you get to keep and invest for your future.
The tax benefits of retirement savings
For the purposes of tax benefits, there are two main classifications of retirement savings. There are accounts for which contributions that get you a tax break now, known as pretax accounts, and accounts for which contributions that get you a tax break later, known as after-tax or Roth retirement accounts.
Pretax retirement accounts include traditional IRAs, as well as most contributions to 401(k), 403(b), and other employer-sponsored retirement plans. Specifically, your contributions are pretax unless you specifically designate them as Roth contributions, and any matching contributions provided by your employer are pretax, even if your contributions are of the Roth variety.
These retirement contributions can be used to lower your taxable income in the current year, provided that you qualify for a deduction and your contribution isn’t greater than the annual limits set by the IRS (more on that in the next section). For example, if $4,000 is withheld from your paycheck on a pretax basis and is deposited into your 401(k), your taxable income for the year will not include this portion of your earnings. If you’re in the 25% tax bracket, this translates to $1,000 in tax savings.
On the other hand, if you choose to contribute to an after-tax account, such as a Roth IRA or with a Roth 401(k), you don’t get a tax benefit in the current year. Instead, your qualifying withdrawals from the account, presumably once you retire, will be 100% tax-free, no matter how large the account has become. For example, if you contribute $100,000 to a Roth IRA over a period of 20 years and the account is worth $500,000, the $400,000 in investment profits can be withdrawn without the IRS’s touching a cent.
Furthermore, lower-income individuals may qualify for an additional tax benefit known as the Retirement Savings Contributions Credit, or Saver’s Credit for short. In a nutshell, this credit is worth up to $1,000 per year for qualifying individuals who save money for their retirement, on top of any other tax benefits.
How much can you save in 2018?
The amount you’re allowed to save in your retirement accounts each year depends on the type of account(s) you have. For 2018, the IRS has announced contribution limits as follows:
- $5,500 for a traditional or Roth IRA, with an additional $1,000 catch-up contribution for individuals who will turn 50 before the end of 2018. The ability to take a traditional IRA deduction or to contribute to a Roth IRA is subject to income limitations. (Note: Catch-up allowances apply to individuals age 50 and older, unless otherwise noted.)
- $18,500 for a 401(k), 403(b), 457, or Thrift Savings Plan, with a $6,000 catch-up allowance. This contribution limit applies only to elective deferrals, not other sources like employer matching contributions. Including all contribution sources, the overall limit for 2018 is $55,000 or $61,000 if you’re 50 or older.
- $55,000 in a SEP IRA, but contributions to these accounts come solely from employers.
- $12,500 in a SIMPLE IRA, with a $3,000 catch-up allowance. Employers have the option to match employee contributions dollar for dollar up to 3% of salary or contribute a flat rate of 2% regardless of employee participation.
How much money will you need to retire comfortably?
Unfortunately, there is no easy answer to this question, but for the majority of Americans, the answer is “more than you think.”
Experts generally suggest that you’ll need 80% of your preretirement income to sustain your lifestyle after retiring, and Social Security isn’t likely to be nearly enough.
According to the often-used “4% rule” of retirement, you can only reasonably expect to spend 4% of your nest egg in your first year of retirement, with cost-of-living adjustments in subsequent years, without fear of running out of money. This means that a million-dollar retirement account can only be relied on to sustainably generate $40,000 in annual income. If you calculate your own retirement number, you may be surprised at how much you’ll need.
The compounding effects can be huge
Fortunately, in addition to being an excellent tax break, those retirement contributions can really grow over long periods of time. I’ve written before that it’s completely reasonable to expect long-term investment returns of about 7% annualized.
Let’s say that you contribute $5,000 to your retirement accounts this year, and increase your contributions by 2% per year going forward to compensate for inflation. Based on 7% annualized returns, this could produce a $580,000 nest egg after 30 years. Contributing $10,000 per year, or $833 per month, would result in twice as much. And this is not including the effect of any employer matching contributions you may get along the way.
The smartest tax move you can make in 2018
There are plenty of tax deductions available to Americans (at least until a tax reform bill passes), many of which are quite lucrative. For example, the mortgage-interest deduction allows many Americans to reduce their taxable income by $10,000 or more each year.
However, the tax benefits of retirement saving combined with the long-term compounding effects of investing in tax-advantaged retirement accounts benefits you in two big ways. You get a nice tax break now or after you retire, and you also get to add to your future financial security at the same time. That’s why increasing your retirement savings is the smartest tax move most Americans can make in 2018, and in every other year, for that matter.
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