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Taxes are a fact of life for Americans, and so is the need to save for retirement. If you own retirement accounts (half of U.S. households do), you might wonder how these two necessities overlap. Depending on the type of account you have, taxes may play a major role in how much you put into or take out of a retirement account.
With a traditional IRA, for example, contributions are generally tax-deductible, but contributions to a Roth IRA are not tax-deductible. Follow along to learn more about the tax implications of retirement accounts as you prepare to file your tax return for 2020.
The main thing to keep in mind if you're doing your taxes and have a traditional IRA is the tax breaks for contributions.
If you (or your spouse) are not covered by a retirement plan at work, you can take a full tax deduction on contributions made to a traditional IRA. The deduction amount depends on what's known as your modified adjusted gross income (MAGI). MAGI refers to your taxable income subtracted by certain deductions you're allowed to take.
The tax deductions you can claim for contributions to a traditional IRA may be limited if you (or your spouse) are covered by a retirement plan at work.
For 2020 and 2021, the amount you can contribute to all of your traditional and Roth IRAs can't exceed $6,000 if you're under 50 or $7,000 if you're over 50.
For the 2020 tax year, you can take the full deduction for your contribution limit if you're single and covered by a workplace retirement plan as long as your MAGI is less than $65,000. A partial deduction is possible if you make more than $65,000 but less than $75,000. Deductions for U.S. consumers in other groups, such as married couples, also depend on income.
If you're not covered by a workplace retirement plan and you're single, a head of household or a qualified widow or widower, you can take a full tax deduction up to your contribution limit no matter what your MAGI is. The same holds true if you're married and filing a joint return, and your spouse is also not covered by a workplace retirement plan. For married couples where one spouse is covered by a workplace plan, the deductions depend on their income.
What about taxes on early withdrawals from a traditional IRA? If you're under 59½, you may be hit with a 10% IRS penalty for an early withdrawal, except in certain circumstances. For example, you may not be penalized if you withdraw money for a first-time home purchase.
Contributions to a Roth IRA are made on a post-tax basis and don't qualify for tax deductions. However, your earnings grow tax-free, and qualified withdrawals aren't subject to taxes or penalties. You may also be able to escape a 10% tax penalty for withdrawing money before you turn 59½ and before the account is five years old if, for instance, you're applying the money to a first-time home purchase.
Contributions made to an employer-sponsored 401(k) retirement plan aren't counted as part of your taxable income. As such, they aren't eligible for tax deductions.
Normally, withdrawing money from a 401(k) before age 59½ results in a 10% tax penalty on the amount taken out. The IRS permits some exceptions to the penalty. For example, you can avoid the penalty if you withdraw money after becoming totally and permanently disabled. You can make penalty-free withdrawals from a 401(k) after you turn 59½.
You will, however, have to pay taxes on the withdrawals you make from a traditional 401(k) just as though they were normal income. You'll report the income on your 1040 form when filing taxes. Withdrawing from a Roth 401(k) works differently, though, since you've already paid taxes on the money you deposited into the account.
Traditional Pension Plan
Generally, contributions to a traditional pension plan are tax-free. If you have an employer-sponsored pension plan, you may be required to pay a 10% penalty on your federal tax return if you take out money before 59½. Exceptions include withdrawals made when you become totally and permanently disabled.
Once you retire, you'll typically pay federal income tax on monthly pension payments or a lump-sum pension payment. However, the sponsor of the pension plan normally withholds taxes when it sends pension checks, meaning at least some of your tax burden should be reduced.
By the way, 14 states don't tax pension payments—including Florida, Texas and Illinois—but the rest do.
Tax Credit for Retirement Contributions
For contributions made to an IRA or employer-sponsored retirement plan, you may qualify for a tax credit known as the Saver's Credit. You're eligible for the credit if you are:
- 18 or older
- Not claimed as a dependent on someone else's tax return
- Not a full-time student
The credit amounts to 10%, 20% or 50% of your retirement contributions, depending on your adjusted gross income and your-tax filing status (like single or head of household). Among other retirement accounts, this credit applies to traditional IRAs, Roth IRAs and 401(k)s. The maximum contribution amount that may qualify for the Saver's Credit is $4,000.
Pandemic Relief and Taxes
The federal CARES Act signed into law in March 2020 delivers some pandemic-related tax benefits for retirement savers.
For example, anyone 59½ or younger can withdraw up to $100,000 from an eligible retirement plan in 2020 without paying the usual 10% tax penalty. In addition, someone can spread out the federal tax due on that withdrawal over a three-year period.
Also, people harmed by the pandemic were able to borrow as much as $100,000 from a 401(k) or IRA from March 27 through December 31, 2020, without facing a tax penalty.
For those already in retirement, the CARES Act enabled older Americans to skip annual "required minimum distributions" from retirement accounts in 2020. If someone wound up taking a required distribution in 2020 before the pandemic struck, they could put back some or all of the money by August 31, 2020. On federal returns for the 2020 tax year, pre-pandemic distributions taken in 2020 must be reflected as tax-free rollovers.
The Bottom Line
Preparing your tax return can be complicated. If you find yourself uncertain about tax deductions and other tax implications for your retirement accounts, visit the Interactive Tax Assistant on the IRS website, check out the AARP Foundation's Tax-Aide program or seek help from a qualified tax preparer.