What Portion of My Income Can I Defer? How Does That Impact My Taxes?
Setting aside money in a retirement plan is one of the most common ways to defer some of your income. Doing so typically lowers your taxable income but is based on the type of retirement plan you participate in. In most cases, there's a limit – set by the government – as to how much you can defer to a retirement plan. Common tax-deferred retirement plans include the 401(k), 403(b), IRA, SIMPLE IRA/401(k), and SARSEP. Income deferment doesn't apply to Roth plans because contributions are taken after taxes.
As of 2020, the maximum amount of your income that you can defer per year is $19,500 before reaching age 50. If you have a retirement account that has a lower limit than the allowable amount, you might consider opening another one, or two, but this doesn't change your limit. So, if you have one account where the limit is $10,000, for example, you can defer $9,500 more in another retirement plan of your choice.
Once you reach age 50, though, you can take advantage of catch-up contributions, which gives you the option to defer $6,500 more for a total of $26,000. Your employer retirement plan might not permit you to contribute more than $18,000 of your income, but you still have a right to defer the additional $10,000. In this scenario it would be up to you to use an individual retirement plan to save any additional amount.
The significant benefit of deferring some of your income is that it lowers your taxable income and the amount of taxes you owe annually during your working years. What ends up happening when you take distributions is, you'll pay taxes on the income, but presumably at a lower rate since you most likely won't be working full-time. It's important to remember that if you take a withdrawal, or distribution as some people call it, from your retirement plan before you reach age 59 1/2, you'll have to pay taxes on it at your standard tax rate, plus a penalty unless you withdraw the money for a qualifying reason (more on qualifying reasons here).
The government doesn't allow you to defer more of your income than the set limit. If you end up deferring more than the allowable amount, you could end up being double taxed on it if your plan administrator doesn't send it back to you on or before April 15 of the following year. Get in touch with your retirement plan administrator if you think you might have deferred more income than you're allowed.