The federal government encourages saving for retirement by giving tax breaks to people who save in specific ways. There are several types of tax perks for retirement savers, each with special rules and restrictions. Here are some of the best tax breaks available to people who save for retirement:
401(k). One of the best ways to get a tax deduction while you save for retirement is through a 401(k) or similar type of retirement account, like a 403(b) or the federal government's thrift savings plan. Employees who are eligible for these workplace retirement accounts can defer income tax on up to $17,500 in 2013, $500 more than in 2012. And people age 50 and older can delay paying income tax on as much as $23,000 in 2013, $5,500 more than younger people. Income tax won't be due on your contributions until you withdraw the money, which you are required to do beginning after age 70 1/2. Traditional 401(k)s generally work best for people who expect to be in a lower tax bracket in retirement than they are now. "You get the employer match and tax-deferred growth, and you get to take it out when your taxes are theoretically going to be lower," says John Dulmage, a certified financial planner for Financial Pathways in Londonderry, N.H.
[Read: Retirement Tax Deadlines for 2012.]
Roth 401(k). Roth 401(k) contribution limits are the same as those for traditional 401(k)s, but the tax treatment is different. Roth accounts allow you to contribute after-tax dollars, and then withdrawals from the account, including the earnings, are tax-free in retirement. Employers are increasingly offering a Roth option, and even allowing workers to convert some of their existing retirement savings to a Roth by paying income tax on the amount converted. A recent Aon Hewitt survey of 300 large U.S. employers found that about half of these companies already offer a Roth account and 29 percent of those without a Roth option are planning to add this feature in the next 12 months. Roth accounts often produce the biggest rewards for young and low-income retirement savers. "I usually recommend that my clients who are in the 15 percent tax bracket use the Roth as the vehicle," says Dulmage.
IRA. Workers can defer income tax on up to $5,500 by contributing to an IRA in 2013, which jumps to $6,500 at age 50 or older. However, the ability to claim this tax deduction is phased out if you have a retirement plan at work and a modified adjusted gross income between $59,000 and $69,000 in 2013 ($95,000 and $115,000 for couples). For investors who don't have a workplace retirement plan but are married to someone who does, the deduction is phased out if the couple's income is between $178,000 and $188,000 in 2013. IRAs generally give you more investment options than a 401(k), and savvy investors can seek out lower fees. "If you have a lot of funds in your 401(k) that have high expense ratios of 1 percent or above, then the best bet is to go with the IRA where you can invest in practically anything you want to," says Kirk Kinder, a certified financial planner for Picket Fence Financial. And while the deadline has already passed to make 401(k) contributions that count for the 2012 tax year, you have until April 15, 2013, to make an IRA contribution that will get you a tax deduction on your 2012 tax bill.
Roth IRA. You can prepay income tax on up to $5,500 ($6,500 at age 50 or older) in a Roth IRA. The ability to contribute to a Roth IRA is phased out for individuals and heads of household earning between $112,000 to $127,000 ($178,000 to $188,000 for couples) in 2013. However, people who earn above these limits may still be able to contribute to a Roth IRA by converting some of their traditional IRA assets to a Roth. Roth accounts give retirees flexibility in retirement because withdrawals are not required during the original account owner's lifetime. "There are no strings attached to when the money comes out," says Philip Watson, a certified financial planner for Watson Planning in Franklin, Tenn. "You don't have to take the money out in your lifetime. You can pass a Roth to your heirs."
IRA tax-free charitable contributions. Individuals age 70 1/2 and older are generally required to withdraw money from their traditional IRAs and pay income tax on each distribution. But retirees in the fortunate position of not needing the money they have stashed away in their IRA can avoid paying income tax on their required withdrawals by donating up to $100,000 of their distributions to charity. To qualify for the tax break, charitable distributions for 2013 must be paid directly from the IRA to a qualified charity by the end of the calendar year.
[Read: Understand Your Rollover Options.]
Saver's credit. Low- and moderate-income people who save for retirement in a 401(k) or IRA are eligible to claim the saver's credit, which can be worth up to $1,000 for individuals and $2,000 for couples. People age 18 and older who are not full-time students or dependents on someone else's tax return can claim this tax credit until their income exceeds $29,500 for singles, $44,250 for heads of household, and $59,000 for couples in 2013. The credit is calculated based on up to $2,000 of retirement account contributions and your income, with the biggest tax credit going to retirement savers with the lowest incomes. For example, a married couple earning $30,000 that contributed $1,000 to an IRA would get a $500 credit. But few people get that much. Among the 6.1 million income tax returns that claimed the saver's credit in 2010, the credits averaged $204 for couples, $165 for heads of household, and $122 for individuals. There's still time to claim the saver's credit on your 2012 tax return. Workers have until April 15, 2013, to make an IRA or Roth IRA contribution that will qualify them for a tax-year 2012 saver's credit.
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