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No one wants to pay taxes on the money they make. But since we do have to pay taxes, there are some simple strategies you can use to leverage your retirement savings to lower taxable income. No matter where you are in your retirement journey—from saving to spending—this article has a tax tip, or a few, just for you.
If you’re starting out on your retirement savings journey …
Make sure you’re contributing to your employer-sponsored retirement plan. When you make tax-deductible contributions to your retirement plan, you’re lowering your taxes while saving for retirement. The money you save in the plan doesn’t count as taxable income. So you’ll owe less in taxes as you save.
When you withdraw your pre-tax money, which hopefully won’t happen until you retire, you’ll owe regular federal, state, and local income taxes on your contributions and any earnings.1
If you’re already investing in your employer’s retirement plan …
Avoid withdrawing money from your employer-sponsored retirement account. Compounding is one of the major benefits of retirement savings, so why interrupt it? Withdrawing from your retirement account could not only reduce the overall amount you could be growing, but your withdrawal may also be subject to taxes and fees.
There are two related tips to consider:
- If your employer offers matching contributions, contribute enough of your pay to receive your employer’s full match.
- If your plan offers an automatic increase, you might be able to automatically increase your contribution rate annually, so you’ll keep saving more every year. If you can take advantage of this, it’s one less thing you have to remember to do.
If you want to save even more for retirement …
Contribute up to the IRS limits each year. If you are age 50 or older, or will reach age 50 by year’s end, and you contribute the maximum allowed up to the 402(g) limit, you may make catch-up contributions. If you reach ages 60 to 63 by year’s end, you may be able to make additional catch-up contributions. Catch-up contributions allow you to save above the normal IRS annual limits.
- Pre-tax contributions help you lower your taxes while you're saving for retirement, and you won't pay taxes until you withdraw the money.
- With Roth contributions, you pay taxes only when you contribute the money.2 If you meet certain conditions, you can withdraw all your Roth money—even any earnings, tax-free. All you need to do is wait until you’re at least age 59½ when you make the withdrawal and make sure your first Roth contribution took place at least five years before the withdrawal.
Explore other tax-advantaged accounts.
- If your employer offers a high-deductible health plan (HDHP) that you’re already enrolled in, a health savings account (HSA) could be a great way to save even more. HSAs offer a triple-tax advantage—your contributions are pre-tax, any account growth is tax-free, and withdrawals for qualified medical expenses aren't subject to taxes. Or if you don’t need the money for medical expenses, you could wait until you are age 65 and use your HSA like you would an IRA.3
- You might also consider a 529 savings plan as a way to save for a loved one’s future and for the potential tax benefit. Many states allow savers to deduct contributions made to a 529 plan. If you spend the money on qualifying expenses, you don’t owe federal or state taxes on 529 withdrawals.4
If you’re getting close to retirement …
Time your Social Security benefits. You can think about Social Security as a key source of your retirement income. And it’s important to think through when it makes the most sense for you to start collecting it. That’s because delaying your benefits from Social Security can increase the monthly payments you’ll receive, while the total amount you’ll get from Social Security will remain the same.
Consider whether or not Roth conversions make sense for you. With Roth conversions, you'll pay taxes on the money in the year you convert it. But you won't pay any taxes on the conversion amount when you withdraw it, assuming you’re at least age 59½ and you made the conversion at least five years earlier.5 Roth conversions aren't for everyone, so be sure to consult with a tax or financial advisor before making a choice.
If you’ve retired …
If you’re approaching retirement and are not where you want to be financially, you may feel the urge to invest more aggressively to make up for lost time. But this strategy can backfire if markets slump, and you could lose a chunk of your nest egg just when you need it most. Learn more about investing before and during retirement.
1 Taxes: The money you take from your retirement account will be taxed as income. You may also need to pay a 10% federal penalty tax if you’re under age 59½. If required by law, Vanguard will withhold some taxes for you.
2 Taxes: Taking money from your retirement account can affect how much you’ll have to pay in taxes. You’ll owe taxes on pre-tax money. You won’t owe taxes on Roth earnings as long as you are age 59½ or older and it’s been at least five years since your first Roth contribution. If required by law, Vanguard will withhold some taxes for you. You may need to pay a 10% federal penalty tax if you take money out early.
3 Taxes: You can only use your HSA for medical costs that are covered. Otherwise, you may have to pay income tax on the money you take out. And if you’re under age 65, you may also face a 20% federal penalty tax.
4 Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.
5 Taxes: When you convert pre-tax money to Roth, you’ll owe taxes on the whole amount. When you convert traditional after-tax money, you’ll owe taxes on just the earnings. You should talk with a tax advisor before you do this. Later, when you take the Roth money out, you won’t owe taxes as long as you meet two conditions. First, you’re at least age 59½. Second, you converted the money at least five years earlier. If you take the money out early, you may have to pay income tax and a 10% federal penalty tax. If required by law, Vanguard will withhold some taxes for you.
For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Vanguard Marketing Corporation serves as distributor for some 529 plans.