Retirement

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Whether you're saving for retirement or you're already retired, it's important to understand how retirement decisions affect your tax return.

Contributing to a qualified retirement plan, such as an Individual Retirement Arrangement (IRA) or a 401(k) plan, can lower your tax bill while you are still in your working years. In fact, saving money on this year's tax return can be a great reason to start or contribute to a retirement plan.

Saving for Retirement Through Employer Sponsored Plans

One of the easiest ways to get started saving for retirement, if your employer offers a 401(k) or similar plan, is to have a percentage of your wages or salary deducted from your pay. This method is easy for two reasons.

First, it's a lot easier to save money when it's a small amount, deducted regularly from every paycheck, and the money never lands in your checking account.

Second, the contribution amount lowers your taxable income, so you have less income tax withheld from your paycheck. Because you're having less withheld, your paycheck won't be reduced as much as you think.

Self-Employed SEP Plan or a SIMPLE IRA

401(k)s and similar plans are not the only way to save for retirement. If you are self-employed, you may want to set up a Self-Employed SEP plan or a SIMPLE IRA.

You may also qualify to open a deductible IRA - an account you open yourself at a brokerage or other institution. IRAs are also a good choice if you need to roll over funds from another account. For example, if you have a 401(k) account at an employer you no longer work for, you can roll over the balance directly into your own IRA account without paying a penalty.

Roth IRAs

Roth IRAs work on a different principle. You can't deduct contributions to a Roth IRA, but when you withdraw money from your Roth IRA at retirement, the entire withdrawal is tax free.

Another advantage of Roth IRAs is that you can generally withdraw your contributions (not interest or other earnings) if you need to, without penalty. This may make you feel more comfortable contributing if you're afraid you may need the money for an emergency.

Social Security Benefits

If you are an employee or are self-employed, you contribute to the Social Security system your entire working life. If you work after full retirement age, you may even pay Social Security tax at the same time you're taking Social Security benefits.

The decisions you make about when you start taking Social Security benefits and how you take them are very important. The longer you put off taking Social Security benefits (up to a point), the more you will receive in monthly benefits.

If you are or have been married, deciding how to take Social Security benefits becomes more complex. You may be able to claim Social Security benefits based on your current or former spouse.

In some cases, you may be better off claiming your own benefits, and then switching over to benefits based on a former spouse. If your former spouse has more than one spouse who can claim benefits based on his or her earnings, the benefits one spouse claims do not affect the benefits available for another spouse.

You can get answers to questions about your own Social Security benefits by creating an account on the Social Security website at ssa.gov.

Retirement Withdrawals and Taxes

When you start taking retirement distributions, the way they affect your taxes depends on the type of plan and other factors.

The general rule is that you pay tax before you contribute it to a retirement plan, you pay tax when you withdraw money from the plan, or some combination of the two.

If you take qualified distributions from a deductible traditional IRA, the distributions are taxable income. The same is true of distributions from deductible 401(k) plans and most other plans that you contributed to with pre-tax money.

If you take qualified distributions from a Roth IRA, you don't include the distributions in taxable income.

When you receive retirement benefits from a pension plan or other qualified plan to which you made after-tax contributions, you may pay tax on only part of the distributions. The Form 1099-R you receive from the financial institution may tell you how much of your distributions are taxable.


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