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How to Manage Your Taxes Like a Rich Person – Your 401(k) Plan as a Tax Shelter

May 14, 2014
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By Laura Tanner, PhD, CFP

Learn more about Laura on NerdWallet’s Ask an Advisor

You don’t have to resort to an offshore bank account to reduce your tax liability.  Did you know that your work retirement plan is one of the simplest and most common tax shelters for your money?  In addition, you may be able to contribute funds to a retirement fund set up outside of work. This post will provide you with an overview of retirement accounts to help you reduce your taxes and plan for a comfortable life in your later years.

Pre-Tax Retirement Account Through Work

Let’s say you make $150,000 a year.  Would you rather pay income tax on that full amount or on $132,500? That’s a no-brainer, right?  If you contribute the maximum of $17,500 to your 401(k), you are reducing your current tax liability.  The amount you will save on taxes depends on your marginal tax bracket.  It gets even better if you are 50 or older, as the maximal contribution increases to $23,000.  Another type of pre-tax retirement account is the traditional IRA (discussed below).  Remember that you are deferring, not avoiding, income taxes on these accounts.  Taxes will become due when you start taking withdrawals from your account.

After-Tax Retirement Account Through Work

Your company may offer a Roth 401(k), in addition to a 401(k) plan.  The contribution limit is the same for each type of plan.  However, with a Roth, you are making after-tax contributions.  This type of plan is attractive to younger employees who might expect that their tax bracket is lower now than it will be during retirement (thus saving on taxes).   One advantage of a Roth 401(k) is that no further taxes are due, even though you may have substantial capital gains (i.e. increases in stock prices) over time, in addition to dividends and interest payments. All of that will remain tax-free. Other after-tax retirement accounts are the Roth IRA and nondeductible IRA.

Note:  Contribution limits are for 2014.  These may be changed in future years to adjust for inflation.

Retirement Accounts Outside of Work

You have maxed out your retirement plan at work, and are able to save additional money.  Depending on your income and marital status, you may contribute up to an additional $5,500 per year to an IRA account (either traditional, Roth, or nondeductible).  If you are 50 or over, make that $6,500 per year. For a detailed discussion of eligibility for contribution to these three types of IRA accounts, please refer to IRS publication 590.

General Strategy for Money Management

Keep in mind that there is a penalty (with some exceptions) for early withdrawal from your retirement accounts (before age 59 1/2). For this reason, you will want to have emergency reserves in cash, as well as additional funds for shorter term goals, such as a down payment for a home or saving for college tuition for your children.  Outside of saving/investing for non-retirement goals, maximizing contributions to your retirement account is a savvy tax strategy. You may not become the next Thurston Howell III (“Gilligan’s Island”), but you are on your way to a worry-free retirement.