When it comes to your retirement, it’s important to plan well in advance. Retirement may seem like a long way away, but making smart decisions now will help set you up for security in your later years. It’s especially important to pay attention to retirement account types and balances during tax time.
Different types of retirement accounts may need to be reported differently on your taxes. Some funds are reported only before they’re invested, while others don’t get reported until after you begin withdrawing from the investment. There are also some investments you can use before retirement, but you need to be aware of potential penalties.
But don’t let the confusing nature of retirement accounts keep you from contributing. Contributing as much as you can to your retirement not only helps safeguard your future, it also reduces your taxable income — which means you save money on taxes.
Watch out for these common mistakes when it comes to taxes and retirement funds.
Withdrawing from a 401(k) or IRA too early
There are circumstances that allow you to withdraw funds from your 401(k) or IRA before the minimum age requirement of 59 ½ without paying an early distribution tax. You can withdraw early if you’re a qualified first-time home buyer or paying for education, in the case of an IRA. Check with the IRS for a full list of exemptions.
If you withdraw early from your 401(k), make sure you understand the tax penalty, which is usually 10% of the amount withdrawn.
An exception related to IRA accounts is if you make a deposit and change your mind by the tax return extended due date for that year. You won’t owe a penalty on the withdrawal, but the money will be added to the year’s taxable income.
Misunderstanding the different IRAs
There are two types of IRAs: Traditional and Roth. It’s important to understand the difference between the two as it affects your tax filing before and after retirement.
In a Roth IRA, your investment will grow tax-free. That means you won’t have to pay taxes on anything you withdraw after you retire. However, you must pay taxes on the money you invest in the account.
With a traditional IRA, you can deduct the amount you invest from your current tax filings. But when you retire and need to withdraw from that account, you will need to pay taxes. The taxes on a traditional IRA can be more complicated depending on your tax bracket.
Not following the required minimum distribution
Once you hit the age of 70 ½, you must begin withdrawing from your IRAs and 401(k) accounts. In addition, there’s a minimum you must withdraw based on tax calculations.
You also need to withdraw larger sums from your retirement accounts as you get older.
The tax penalty for not withdrawing from your accounts can be up to 50% of the amount you were supposed to take out. However, there is no required minimum distribution if you have a Roth IRA. But your heirs would have to pay taxes on any amount remaining after your death.
Understand tax responsibilities on retirement funds
Individual tax situations can often get more complicated as you get older and find yourself dealing with more investments, different types of deductions, and perhaps even sources of unearned income. That’s why it’s important to get the help of a licensed tax professional before you file your taxes. Mistakes on your tax return can mean missing getting a smaller tax return, or worse — owing money to the IRS.
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