Tax-advantaged retirement plans can help you avoid taxes and save for your retirement. Contributing to a 401(k) or a Roth is if your employer offers one can save you a lot of money.
To start, you should increase your contribution rates to the maximum allowed. Because compounding is tax-free in Roth accounts and tax-deferred otherwise, boosting contributions now can make a big difference when you retire.
With a 401(k), an employee elects to have a certain amount of pay deferred and contributed by an employer to the plan. The contribution limit for 2020 is $19,500. Employees age 50 or older by year end are also permitted to make additional “catch-up” contributions of $6,500, for a total limit of $26,000 in 2020.
401(k) contribution limits for 2021 will remain the same as for 2020.
Contributing to a traditional 401(k)
Benefits of this type of plan include
- Pretax contributions, which reduce your modified adjusted gross income (MAGI) and can also help you reduce or avoid exposure to the 3.8% net investment income tax
- Tax-deferred asset growth, which means you pay no income tax until you take distributions
- In some cases, employer matching for pretax contributions
If you already have a 401(k) try to increase your contribution rate to get close to the $19,500 limit (with an extra $6,500 if you’re age 50 or older) if possible, remembering that your paycheck will be reduced by less than the dollar amount of the contribution. Contributions are pretax, so income tax isn’t withheld.
Contributing to a Roth 401(k)
Some employers include a Roth option in their 401(k) plans. If your employer does, this allows you to designate some or all of your contributions to the Roth. Such contributions don’t reduce your current MAGI, but qualified distributions will be tax-free.
These contributions may be especially beneficial for higher-income earners because they don’t have the option to contribute to a Roth IRA. You can expect a decrease in allowable contributions to a Roth IRA in 2021 if your adjusted gross income (AGI) in 2021 exceeds:
- $198,000 (up from $196,000 for 2020) for married joint-filing couples, or
- $125,000 (up from $124,000 for 2020) for single taxpayers.
If you’re a married joint filer and your 2021 AGI equals or exceeds $208,000 (up from $206,000 for 2020), your ability to contribute to a Roth IRA in 2021 will be eliminated entirely. The 2021 cutoff for single filers is $140,000 or more (up from $139,000 for 2020).
A wise approach
Contact us if you have questions about how much to contribute or how to divide contributions between traditional and Roth 401(k) accounts. We can discuss the tax and retirement-saving strategies in your situation.