Note: Last September I introduced my “Understanding the Tax Game” series with my first post. If you’d like, you can read it here. This is the second part of this series, and I’ll continue adding to it in the future.
When it comes to taxes, pretty much all of us are interested in one thing: How do I pay as little as possible? This is a great question, and it’s really what this Understanding the Tax Game series is all about. It’s helpful to look at taxes as a game with rules. If you understand the game well enough and play by the rules, you have a better chance of “winning” the game.
I sometimes notice people getting caught up in minor issues when it comes to tax savings, like trying to identify each and every charitable contribution made. This is an important tax deduction to consider, but it’s minor compared to others. When it comes to taxes, you need to sweat the big stuff.
“The big stuff” are areas that will make the biggest impact on how much you pay in taxes each year. I’d like to focus on one of the biggest: Retirement Savings.
Saving for Retirement
401ks, IRAs, SEP IRAs, SIMPLE IRAs, and 457 plans are all tools you can use to save money for retirement. These accounts have tremendous tax advantages too. Every dollar you add to a retirement plan lowers your taxes for this year and defers the taxes owed until the money is withdrawn, typically when you’re retired.
For example, assume you earned $100,000 in 2018. You’re married and file your taxes jointly. Right off the bat you have a standard deduction of $24,000. Great; everyone’s happy. This is a new deduction as of this year, available to all married joint filers. If you received no other deductions your taxes paid would look like this:
With no additional retirement savings, your only deduction on your taxes is the standard deduction. Your effective tax rate is 14.8%. Not bad.
Now suppose you contribute to your workplace 401k plan in addition to claiming the standard deduction. Suppose you contribute 10% of your wages, or $10,000.
Not only can you save a significant chunk of money through a retirement plan each year, but you receive an immediate tax deduction for the money you put into these accounts. In our example, the taxpayer realized an additional tax savings of $2,200. Again, taxes will need to be paid when the money is withdrawn, but the principle is to defer paying taxes in your peak earning years, and pay them later when you’re earning less income and taxed in lower tax brackets.
Contribution limits for retirement accounts vary. Here’s a breakdown of how much you can put in each account per year. Notice these amounts can be into the five digits:
401k, 457, 403b = $19,000 + $6,000 maximum catch-up contribution if over 50
Traditional IRA = $6,000
SIMPLE IRA = $13,000 + $3,000 maximum catch-up contribution if over 50
SEP (Self Employed Pension) IRA = the lesser of $56,000 or 25% of compensation
Let’s say you’re over 50 and trying to catch up on your retirement savings. Here’s what this could look like:
In this example, the taxpayer realized an additional tax savings of $5,500.
The tax game is all about understanding the rules and using those rules to lower your taxes. I would argue that utilizing retirement accounts is the most beneficial way to do so. You can set aside a significant amount of money each year, reduce the amount of taxes paid, defer taxes owed to periods when you’re earning less income, and your investments grow tax free over time.