Understand the ways retirement accounts help you save taxes and build more wealth for retirement. Plus, whether moving to a different state in retirement could affect the tax you have to pay. Get the Money Girl Book at http://MoneyGirlBook.com
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360 MG How Retirement Accounts Save Money on Taxes
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I'm Laura Adams, author of the award-winning book, Money Girl Smart News to Grow Rich, available in paperback at your favorite bookseller. For more money tips that are not included in the weekly podcast, be sure to sign up for the free Money Girl newsletter. You'll find it on the Money Girl page at quickandertietips.com. When you're there, please connect with me on social media like Facebook, Twitter, Google+, or read a transcript of this show, which is episode number 360, called How Retirement Accounts Save Money on Taxes. If you're a regular Money Girl reader or podcast listener, you know that I recommend investing through tax-advantaged accounts, like an IRA or Workplace 401(k) to build your retirement nest egg. But how do retirement accounts actually help you save money on taxes? This was a common question that I heard recently at a financial seminar that I presented to a large company in New York. In this episode, I'll cut through the confusion and explain terms like tax deferred and tax-free. You'll find out how traditional and Roth retirement accounts allow you to pay less tax and accumulate more wealth to spend in retirement. Plus, I'll finish by answering a listener question about whether moving to a different state in retirement could affect the tax you have to pay when taking money out of retirement accounts. Since taxes take a big bite out of income, it's smart to cut them every way legally possible. Fortunately, we get a nice tax break for something that we should be doing anyway, saving for retirement. Retirement accounts can cut your taxes in two main ways, tax deductible contributions, and tax-free withdrawals. I'm going to explain both of those for you. Contributions you make to a traditional retirement account, such as a traditional 401(k) or IRA, are tax-deductible. In other words, you make them on a pre-tax basis. Workplace plans deduct contributions directly from your paycheck before taxes are even taken out. Or if you make IRA contributions with after-tax money, you get to claim a deduction for those amounts when you file taxes. For instance, if you earn $50,000 and contribute $5,000 to a traditional IRA or 401(k), you only have to pay tax on $45,000 that year, not on $50,000. Avoiding tax on $5,000 of income could save you about $850, depending on your situation in the state where you live. Reducing the amount of income you have to pay tax on is a smart way to keep more of your money and pay less to the government. Annual contribution limits for retirement accounts are established each year by the internal revenue service. For 2014, you can contribute up to the following amounts for an IRA or workplace plan. If you have an IRA and are under age 50, you can put in up to $5,500. If you're age 50 or older, you can contribute as much as $6,500. 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That means you don't have to put your life on hold to pursue your professional goals. Instead, enjoy learning your way and earn your degree without missing a beat. A different future is closer than you think with Capelli University. Learn more at Capella.edu. For workplace plans like a 401k, 403b, or 457, if you're under age 50, you can put in 17,500. Or if you're age 50 or older, you can put in up to 23,000. Plus, employers can add additional funds, such as matching or discretionary contributions to your account, which allow you to exceed these annual limits that I just mentioned. However, with a traditional retirement account, the tax man catches up to you eventually. Any amount you withdraw is subject to ordinary income tax, plus a 10% penalty if you're younger than age 59 and a half. Distributions are added to your total income for the year. You must pay ordinary tax, but not capital gains tax, based on your income tax bracket at the time you withdraw traditional funds. No matter if the money comes from your original contributions or their earnings. Traditional retirement accounts are known as tax-deferred accounts, because you delay all taxation until you take distributions in the future. In addition to traditional accounts, there's another type of retirement account you've probably heard of called a Roth. These flip-flop taxation from a traditional account, because contributions to a Roth are not tax deductible, which means you must pay tax on them up front. For instance, if you earn $50,000 and contribute $5,000 to a Roth IRA or Roth 401k, you must pay tax on $50,000 that year. There's no immediate tax benefit for Roth contributions. However, the great feature of a Roth is that future withdrawals that you make after age 59 and a half are completely tax-free, unlike with a traditional account. A Roth allows you to avoid paying one penny of tax on growth in the account that may have accumulated over decades. You can even withdraw your original contributions tax-free before reaching age 59 and a half if you've owned a Roth account for at least five years. But withdrawing any amount of earnings from a Roth IRA or workplace plan triggers a 10% early withdrawal penalty. Let's say you put $5,000 a year into a Roth IRA for 30 years, which is a total of $150,000 in contributions. If that amount grows and mushrooms into a value of $450,000, you'd avoid tax on the difference or $300,000 of earnings. Depending on your situation, that might give you a tax savings of $60,000. As long as your money stays in a traditional or Roth retirement account, you won't pay any tax on investment earnings. They get reinvested and compound year after year without any federal or state tax bill. As I previously mentioned, you'll never get a tax bill from a Roth account when you withdraw money in retirement, but you will for traditional accounts. I had a great question from a listener named Paul who asks, "I have traditional and Roth retirement accounts and have been contributing to them in Texas where there is no state income tax. If I decide to retire to a different state that does have income tax, would I have to pay income tax on my retirement distributions?" The good news is that no matter where you live, you won't have to pay any federal or state tax on Roth distributions. However, your traditional account withdrawals will be subject to both federal and state income tax depending on where you live in retirement. I'm glad you're listening to Qing. That's all for now. Courtesy of Money Girl, your guide to a richer life. Hi, my name is Patrick Adams. You may know me as Mike Ross on the TV series, Suits. And I'm Sarah Rafferty, and I played Donna Paulson on Suits. And we have a podcast called Sidebar, where every week we watch and discuss an episode of the show. Because here's the thing, neither of us have really watched it. 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