Retirement Savings Account with Tax Deductions

May 16th, 2010 | by Allison Thompson |

When you divert money into a retirement savings account you’re not only planning for your future, but you’re also racking up some tax benefits in the process. The specifics of tax deductions you can obtain on the contribution amounts you make to your retirement savings account depend on the type of retirement account into which you’re making contributions–Individual Retirement Account (IRA) or 401k. Both types of accounts, however, do allow you to take tax deductions in the current tax year.

Traditional IRAs and 401ks

Traditional retirement savings accounts permit you to deduct your contribution amount in the current tax year. When you file your federal tax returns, you will have to submit proof of the contribution amount you made. The contribution amount is deducted from your income, which reduces your taxable income for the year and lowers your tax cost. As an added bonus, the account grows tax-deferred, so you aren’t required to pay taxes until you start making withdrawals from the account.

Roth IRAs

A Roth IRA is different from traditional retirement savings accounts because you do not receive any tax benefits from the contribution amount in the current tax year. The money you deposit into the account, however, also grows on a tax-free basis. With Roth IRAs, you pay taxes on the money upfront so when you withdraw funds from the account for retirement, you do not pay tax on the withdrawal amounts.

Choosing the Best Retirement Savings Account

Everyone has a different financial situation, so there is not a one-size-fits-all solution as to which retirement savings account is the best one for you. Base your decision on your current tax bracket. If you have a low income, you are also in a low tax bracket. In this situation, a Roth IRA may be best because you will pay taxes at your current tax rate. The opposite is true for high income tax bracket individuals and those who expect their income to increase over the years as they near retirement age. You may also want to consider your needs over the years. Some invest in Roth IRAs because of the ability to borrow against in the retirement savings account to buy a home or fund a college education. The moral of the story is that it is important to consider your long-and short-term objectives and needs when deciding which type of retirement savings account offers the most benefit to your personal financial situation. Most individuals also seek the advice of a tax and/or financial advisor to help them make an educated decision.

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