When it comes to retirement savings, understanding tax implications is a key component of successful retirement planning. This article breaks down 4 key terms needed to understand retirement savings and tax options for small business owners and employees.
1. Employer Contributions (“Free Money”)
An employer contribution to a retirement account is money made available by the employer for employees for the specific use of being added to a retirement investment vehicle. Many employers provide contributions toward employee retirement accounts. For example, an employer may match a 401(k) contribution up to 3 percent. An employer may also contribute to eligible employees' Health Savings Accounts as a strategy for providing retirement savings.
For employers, this offers an attractive benefit and encourages employees to save for their own retirement. For employees, this is essentially free money they can invest for their future. And remember, free money - whether taxable or tax-free - is still free money!
2. Tax-Free Money
Tax-free money is income you do not need to pay taxes on - now, or in the future. Money earned in certain types of retirement accounts is tax-free when withdrawn, as long as specific conditions are met. Examples of common accounts that allow tax-free money to be earned include:
- Roth IRAs
- 529 College Savings Plans
- Municipal bonds
- HSAs, under certain conditions
It may be helpful to note the money initially deposited into these accounts occurs after taxes, and these accounts are generally not included in income tax deductions. As the accounts earn interest, that interest will not be taxed when withdrawn according to the stipulations of the account.
3. Tax-Deferred Money
Tax-deferred savings plans are very common and allow us to put money into retirement accounts without paying taxes on the money that is contributed. The investments accumulate over time, and the money in the account is taxed at the time it is withdrawn from the account. With tax-deferred money, you defer taxation on your income either until withdrawal from the account or until a particular date.
Tax-deferred money is accounted for when calculating your modified adjusted gross income for your annual tax returns. Tax-deferred savings plans are used most commonly in retirement savings accounts such as IRAs, 401(k)s, and RRSPs, but are also available for education savings plans and other accounts.
4. Taxable Money
The last definition is taxable money - this is all money not otherwise classified and is taxed whenever it is received.
Conclusion
When thinking about retirement savings for yourself as well as employees, the tax savings received is an important contributor to the overall money saved. When thinking about offering employee retirement benefits, it is key to understand these four key definitions: free money, tax-free money, tax-deferred money, and taxable money.
What questions do you have about retirement savings and taxes? Leave a questions below. We’d be happy to answer!
