We have almost reached the deadline of this long tax season. Normally, personal tax returns are due by April 15th. Because of the pandemic, the due date was extended until July 15th. For any procrastinators out there, you can file an automatic extension form to extend your due date until October 15th. You must send in any expected taxes due with this extension request.
Many people think that once they file their tax return, they do not need to think about it again until next January when they start receiving 2020 tax documents. This might prove to be a big mistake. Many decisions that you make during the year have an impact on how much you must pay in taxes. If you contribute to a qualified retirement account such as an IRA or 401(k), you get to deduct this amount from your federal taxes due. Pennsylvania does not allow this deduction, however they do not charge taxes upon distribution. There are certain tax regulations that limit the amount of any contributions.
Many people get an employer match when contributing to a 401(k). If you are not contributing, you do not get this free match. Since most people do not get a pension anymore, it is important to start saving early and let your money grow in these taxes deferred accounts. There are a number of reasons that it is a good idea to contribute to qualified accounts. The money grows tax deferred during your working years. You must start making withdrawals by age 72. When you do take money out, you are taxed at the ordinary income tax rate.
A mistake many people make is saving almost all of their money in qualified accounts. The IRS recognizes two other types of accounts .Non-qualified and tax preferred. The he first type might be money you have left over from your paycheck after paying bills, a gift, inheritance or from being a beneficiary of life insurance policy. It also may be from selling an extra vehicle or cabin. Uncle Sam is not your partner in these funds. You only owe tax on any earnings.
The last group, tax preferred might include Roth IRAs, properly structured life insurance and HSAs. You do not get a tax deduction when making your contribution, but you do not have to pay taxes when taking distributions if you follow the rules. Your allocation is best when your assets are spread between all three tax funnels.
We have witnessed during the pandemic that many people did not save enough to financially protect their families. Saving somewhere is very important. However, if the vast majority of your savings is in qualified accounts, you can be creating a major tax headache in the future.
Taking money out of 401(k) s and IRAs can have an impact on how much of your Social Security income is taxed. It also multiplies the negative impact upon the death of one spouse. This situation is often known as the widow’s penalty although the tax code is gender neutral and equally affects both genders. The harsh effects of this can be lessened by having your money more evenly distributed between the three tax funnels.
Next week, we will discuss more ways to lower future tax obligations.