What to Know About Tax Advantages of a Retirement Program

While there are a variety of different retirement vehicles available, the retirement tax advantages are limited to two varieties. While both offer incentives, the benefits of one may be more advantageous to some groups than others.

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There are now Roth 401k's provided by an employer and Roth IRA's setup and funded by an individual. These are "after tax" plans, meaning they are funded with dollars after FICA taxes have been withheld on your paycheck. The advantage to these comes, as once a plan is funded, the individual will never pay taxes on the earnings (capital gains, dividends or interest) again (assuming they do not withdraw the proceeds before age 59 ½).

myRA is a new retirement savings account that has a direct connection to the United States Department of the Treasury. It is an alternative retirement savings method that works especially well for those who do not have a retirement savings plan offered through their place of employment or who are self-employed. There are some significant benefits to this plan, and it even features some tax advantages as well.

The myRA plan is sometimes referred to as a "starter" retirement savings plan. The accounts are backed by the government, and those that use them do not have to pay any fees to get the account set up or to maintain it. Employees can even contribute directly from their paychecks.

This plan is specifically for Americans who are considered low and middle income, as well as other Americans who do not have access to employer-sponsored retirement plans. This could include part-time workers or those who work at small businesses or startup companies. The only real qualification is that your 2016 income must be under $194,000 for married couples or $132,000 for an individual.

There are also tax deferred retirement programs such as a 401k, 403b, Simple IRA (employer supplied) and Traditional IRA. Essentially, the advantage to these retirement plans is that the money invested in the plan comes out of your paycheck before taxes do.

Here is an example of how this works, assume that someone makes $1,000 a week and that they are in the 25% tax bracket. As such they will pay $250 in taxes, and ordinarily take home $750. Now let's assume instead that this individual contributed 10% of their earnings ($100) to a deferred plan, it would lower the amount of income that is taxable to $900 and instead leave them with $675 in take-home plus $100 in their retirement account. This is a total of $775 an additional $25 per pay check ($1,300 per year). Note - for simplicity, in this example we've used a flat tax rate, not progressive.

As an individual's tax rate increases the saving in using a deferred account becomes greater. Also, since many states also exempt these contributions from state taxes, it is possible to benefit even more than what is shown in this example.

As long as the withdrawal occurs after age 59 ½, the money will be subjected to ordinary income tax rates. Anything taken before this age, may include a penalty on any withdrawal. If your financial circumstances require an early withdrawal or distribution before you reach age 59½, you must be aware that retirement tax penalties will apply.

In addition to having to include the distribution as part of your taxable income, you will have to pay a 10 percent penalty unless you qualify for one of many exceptions including these four common ones:

  • The distribution is going to a beneficiary after your death.
  • You are permanently disabled.
  • The money is going to pay deductible medical expenses that total more of than 10 percent of your annual income.
  • The withdrawal occurred as a result of an IRS levy on the retirement plan.

One of the other benefits, in either type of plan an employer-sponsored account often includes an employer match of some sort. Matches, go straight to the employee's retirement account and are typically given as a percentage of the employees salary (up to a certain amount, provided the employee contributes that same amount). There are guidelines specifying how much the employer may offer and how they can offer it. The important part is this is free money to the employee, all they have to do is participate.

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