Retirement plans like 401(k)s and traditional or Roth IRAs can be an easy and effective way to save for retirement. Many investors favor these accounts for their significant tax advantages, which can include tax-deductible contributions.
Contributions to a traditional 401(k), IRA, and other retirements plans are usually deductible up to a limit. However, not all retirement plan contributions are tax deductible. The type of retirement plan you have will determine whether you can reduce your taxable income with your contributions. Learn how tax advantages vary and when your contributions to retirement savings are tax deductible.
Roth vs. Traditional IRA
With traditional IRAs, you make contributions with pre-tax funds. So, your contributions are deducted from your total income each year, reducing your tax obligation for that year. Later on, when you withdraw funds from your traditional retirement account, you’ll pay taxes according to your income bracket.
In contrast, Roth account contributions are made with after-tax income, and they are not tax deductible. Instead, Roth accounts provide tax advantages when you withdraw the funds after you reach age 59½ and have held the account for five years. At that time, you can make tax-free and penalty-free withdrawals, including on any earnings.
How IRA and 401(k) Retirement Plans Work
Contributions to traditional IRAs and 401(k)s are tax deductible. But with 401(k)s, you don’t need to claim them as deductions on your tax return. Instead, your employer will exclude the amount you contributed from your taxable income.1
How different retirement plan contributions are taxed can also depend on other factors like the plan’s contribution limits, age limits, and income limits.
Contribution Limits
For IRA plans, you can contribute up to $6,000 (or $7,000 if you’re over 55) for 2022. If you contribute more than this amount, the excess will be taxed at 6% per year for each year it remains in the IRA.2
For 401(k) plans, you can contribute up to $20,500 ($27,000 if you’re over 55) for 2022. With employer contributions included, your account can receive up to $61,000 ($67,500 if you’re over 55). If you contribute more than the limit, you will face a 10% penalty on the excess amount.3,4,5
You can contribute to both a 401(k) and an IRA at the same time. However, contribution limits apply to the total contributions for each type of account, no matter how many accounts you have.
Age Limits
You can start contributing to an IRA at any age if you have taxable income, and there is no maximum age limit. As long as you are earning money, you can continue to contribute even if you are taking required minimum distributions (RMDs).6
For 401(k)s, employers must allow you to participate in their plan (if they have one) after you’ve worked for the company for one year and if you’re 21 or older. Then, you can continue to contribute for as long as you are earning income.7
Income Limits
If you earn above a certain threshold, your tax advantages and contribution limits begin to phase out for certain types of retirement plans.
For IRAs, individual filers earning $129,000 or less in adjusted gross income can contribute up to the maximum. You can contribute a reduced amount if you earn between $129,000 to $144,000. You cannot contribute to an IRA if you earn more than $144,000.
If you’re married and filing jointly, you can contribute the maximum if you earn $204,000 or less, and a reduced amount if you earn between $204,000 and $214,000. You cannot contribute to an IRA if you earn more than $214,000 combined.8
With 401(k)s, you can contribute up to the maximum to a 401(k) no matter how much you earn. However, if you earn more than $305,000 for 2022, your employer’s matching funds may be more limited.9
Are Retirement Savings Taxed?
Your retirement savings are not taxed during the time they are in your account. Instead, you’ll pay income tax either when you contribute or when you withdraw the funds, depending on the type of account.
So, if you invested your retirement savings in assets that have increased in value, you will not pay taxes on those earnings each year, but you may have to pay taxes on them when you withdraw the funds.
How RMDs Are Taxed
A required minimum distribution, or RMD, is the minimum amount you must withdraw from your retirement account each year starting at age 72 (or 70½ for people who were born before July 1, 1949). RMDs are taxed as income.10
You’ll pay taxes on RMDs along with other sources of income according to the rate of your tax bracket. Many investors have a lower tax bracket during their retirement years, so they’ll pay less in taxes than they would have during their working years. That’s the significant advantage of a tax-deferred retirement plan.
RMDs are required for tax-deferred accounts like traditional 401(k)s and IRAs, but Roth IRAs don’t require them while the account holder is still alive. Roth 401(k) accounts do have RMDs, but they are tax-exempt because the contributions are made with after-tax funds.11
f you don’t take your RMD, you’ll be taxed 50% on the amount you did not withdraw.
The Bottom Line
Understanding which retirement plan contributions are tax deductible will help you choose the best retirement account for your situation. Consider consulting a professional financial advisor for guidance on which type of account may suit your personal situation.
Have Questions About Retirement?
Talk to a qualified financial advisor today to get professional retirement planning advice today. Need help finding a financial advisor in your area? Give us a call today so we can match you with a fiduciary advisor who will put your needs first.
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1 IRS.gov, “401(k) Plan Overview” https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
2 IRS.gov, “Retirement Plan Topics – IRA Contribution Limits” https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
3 IRS.gov, “401(k) Plan Fix-It Guide” https://www.irs.gov/retirement-plans/401k-plan-fix-it-guide-elective-deferrals-werent-limited-to-the-amounts-under-irc-section-402g-for-the-calendar-year-and-excesses-werent-distributed
4 IRS.gov, “IRS Announces Changes to Retirement Plans for 2022” https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
5 IRS.gov, “2022 Limitations Adjusted as Provided in Section 415(d), etc.” https://www.irs.gov/pub/irs-drop/n-21-61.pdf
6 IRS.gov, “Retirement Plan Topics – IRA Contribution Limits”https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits
7 IRS.gov, “401(k) Plan Qualification Requirements” https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-qualification-requirements
8 IRS.gov, “Amount of Roth IRA Contributions That You Can Make for 2022” https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022
9 IRS.gov, “401(k) Plans – Deferrals and Matching When Compensation Exceeds the Annual Limit” https://www.irs.gov/retirement-plans/401k-plans-deferrals-and-matching-when-compensation-exceeds-the-annual-limit
10 IRS.gov, “Retirement Topics – Required Minimum Distributions (RMDs)” https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
11 IRS.gov, “Retirement Plan and IRA Required Minimum Distributions FAQs” https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
This information is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.
Converting from a traditional IRA to a Roth IRA is a taxable event.
A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
