7 Tips to Maximizing the Tax Benefits of your 401k(s) and IRA(s)

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Tax season is almost over but there’s still time to maximize the tax benefits of your 401k(s) and IRA(s). Before you can begin reaping the potential benefits however, you’ll need to ask yourself a few questions relating to your current station in life and where you’d like to be come retirement age.

1. Do you plan on working to the age when you can withdraw retirement funds penalty free or retire early?
2. Do you need the benefit of tax deductions right now due to a tough financial situation?
3. Are you in a higher tax bracket right now than you think you will be in retirement?
4. Do you think your lifestyle will be less or more expensive in retirement?

Without an answer to these tough questions, it is very challenging to know whether to invest your retirement savings through the traditional or Roth options available to you. And what about an SEP IRA? When can that come into play?

When it comes to choosing the retirement account that makes the most sense for you, there are some general tips you can follow. Your answers to the previous four questions will only enhance your ability to get the most out of these tips.

1. Get Free Money First
Before considering an IRA, you should first make sure that you are getting the maximum benefit out of your employer’s 401k plan. What this means is that before contributing funds to any IRA, you should get the maximum match from your employer in your 401k. If you’re not sure what that amount is, you have some homework to do. Once this maximum match has been achieved, you can move over to IRA’s.

2. Know Your Limits
They can change annually so it’s worth checking. For 2009, the IRS maximum allowed contribution per individual for 401k’s is $16,500, with an additional catch-up contribution for those 50 and older. For both IRA’s, it is $5,000 (combined per individual), with a catch-up contribution of an additional $1,000. In 2010 and beyond, limits are indexed to inflation.

3. Understand What a Tax Deduction is
Every dollar you contribute to a traditional 401K or IRA is a dollar taken off the top of your taxable income for the present year. For instance, if I earned $40,000 this year and maxed my traditional IRA and 401k contributions, my taxable income would be $18,500 versus $40,000 ($40,000-$16,500-$5,000 =$18,500). If I’m in the 15% tax bracket, this would shave $3,225 off of my $6,000 tax obligation for the year.

4. Understand the Term ‘After-Tax’
Both the Roth 401k and IRA options are ‘after-tax’. This means that your contributions are after taxes have already been subtracted. You are getting taxed today, for the benefit of not being taxed when you start getting distributions later on. With the traditional options, you are getting the benefit of not being taxed today, but you will be taxed on your distributions later on.

5. Understand the Trade-offs
If you plan on retiring early, opting for the traditional options versus the Roth can allow you to save your tax cuts towards this goal, if you are disciplined enough to do so. But there is always a catch, right? You will have less money in retirement because you are taxed on your distributions through the traditional.

6. Know Yourself
If you plan on traveling the world and living lavishly in retirement, it makes sense to take the tax hit now with the Roth options so that you have more money in retirement. If you plan on living humbly in retirement (after all, any mortgages should be paid off by then), then you may want to take the tax hit down the road.

7. Understand Your Current Situation
If you are making a fair wage but are drowning in debt and will be in the red for the year, then it would rarely make sense to opt for the Roth options when you could be getting the tax benefits of the traditional options today, which could be a life saver for you.

The Third Option

We’ve discussed Roth and traditional options fairly extensively, but have not yet discussed the SEP IRA. The circumstances allowing you to contribute to an SEP IRA differ from the traditional and Roth IRA options. You may open an SEP IRA if you have self-employment income from freelance or other work. Other than contribution limits, SEP’s pretty much operate in the same way as traditional IRA’s.

As we discussed in the previous IRA article, SEP’s are a highly desired option for the self-employed who have already maxed out on their traditional and Roth contributions, yet still want additional tax deduction benefits. The maximum dollar allocation is $49,000 in 2009.

For more of GE Miller’s writing, visit 20somethingfinance.

To learn more about contributing to an IRA, visit Mint’s IRA Advisor.

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