Establishing a retirement account and making contributions consistently, year after year is one way to save.  The savings achieved using a retirement account can be seen in federal and state taxes because contributions are “pre-tax” which means that contributions reduce total wages and are not taxed currently with other income, resulting in a bigger tax refund.  The more that is  contributed to an employer sponsored retirement account, the less federal tax withholding there will be.  If nothing or less is contributed to an employer sponsored retirement, the more federal tax withholding there will be.  This more and less retirement contributions and federal tax withholding can be seen by reviewing your bi-weekly earnings statement and annual Form W-2.

Retirement accounts

A retirement account can be any type of account you choose to set up for when you retire.  More than one type of account can be designated as a retirement account, for example you can contribute to an employer sponsored plan or an individual retirement account (IRA); you can set up a fund to purchase and hold stocks and bonds; you can acquire real estate as an investment with plans to sell shortly before or during retirement.  The important thing is that you establish a plan and make contributions consistently based on the amount you can afford, the amount you feel comfortable setting aside, and what your expectations are for when you retire.

Income Tax Savings

When contributions are made to a retirement account, “Wages, tips, and compensation” in box 1 is less than the “Social security wages” in box 3 of Form W-2.  The amount in box 1 is reported as “Wages, salaries, tips, etc.” on Form 1040, rather than the amount in box 3, which results in less income being reported and taxed.  If no contributions are made to an employer sponsored retirement account during the year, the amount in box 1 and box 3 will be the same.

Retirement Savings Credit

In addition to resulting in a bigger income tax refund, the retirement savings credit is available to individuals who make contributions to certain types of  retirement accounts.  The savings contribution must be made to a traditional or Roth IRA; 401(k), 403(b), governmental 457, SEP, or SIMPLE plan; qualified retirement plan defined in internal revenue code section 457; and retirement plan of a tax-exempt organization.  This credit can be taken be taken if certain income limits are met by individuals who are at least 18 years old at the end of the tax year, who are not full-time students, who cannot be claimed as a dependent on someone else’s tax return.

See Pub. 17, Your Federal Income Tax (For Individuals) for more information about this credit.

Use Form 8880, Credit for Qualified Retirement Savings Contributions to compute the amount of your credit.