Every year around tax time, I hear the same question: What can I do so I don’t owe so much tax next year? While there are several ways to save on your tax bill, one of the easiest ways is to put money away for retirement.
These days, taxpayers have many options for retirement savings: Traditional IRA, Roth IRA, 401k, Roth 401k, SEP IRA, 457b, SIMPLE IRA – just to name a few. The ones that will help you with your tax bill now are those that allow pre-tax contributions, such as a 401k and Traditional IRA. Making pre-tax contributions means that you won’t pay tax on that money now (taxes will be deferred until you make withdrawals during retirement), which means a lower taxable income. Having a lower taxable income means less tax due, possibly even a lower tax bracket, and even a potential increase in tax credits.
Let’s take, for example, Bob, age 35, a single taxpayer with a child, age 9. Bob has a good job, and his W2 shows $230,000 in wages for 2019. If Bob makes no contributions to his employer’s 401k plan, and assuming he takes the standard deduction for a Head of Household individual ($18,350 for 2019), he will have a taxable income of $211,650 and a tax liability of $47,853, putting him in the 35% tax bracket. Additionally, Bob will be entitled to $500 of the child tax credit.
However, if Bob maximizes his 401k contribution ($19,000 for 2019), his W2 income would then show $211,000 in wages. After his standard deduction, Bob’s taxable income would be $192,650, with a tax liability of $41,546, putting him in the 32% tax bracket. Also, Bob would now be entitled to $1450 in child tax credit.
As you can see, by maximizing his retirement fund contribution for 2019, Bob will decrease his taxable income by $19,000, move to a lower tax bracket, and increase his child tax credit by $950. Even better, Bob is now well on his way to saving for retirement!