If you’re worried that you might owe some money to this IRS this year, or you’re hoping for a juicy tax refund, there’s one way to increase the possibility of getting more money back: pay more into your retirement accounts.
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It matters what kind of retirement accounts you have, but financial experts explain that by utilizing this tax strategy, you may very well end up with more money in your pocket than you anticipated.
You Can Lower Your Taxable Income
Contributing to tax-advantaged retirement accounts like a 401(k) or an IRA is a powerful strategy to get money back, according to Mike Kojonen, founder and owner of Principal Preservation Services LLC.
“For example, if you contribute the maximum allowed to your 401(k), you’re effectively lowering your taxable income for that year. This reduction can drop you into a lower tax bracket, potentially leading to a larger refund. I’ve seen clients save thousands on their tax bill simply by maximizing their contributions to these types of accounts,” Kojonen said.
To show what this looks like in the numbers, Justin Rush, CFP with JGR Financial Solutions, plays out a scenario using a hypothetical person named Bob.
Let’s say Bob makes $100,000 a year. For the sake of easy math, Rush said he pays 20% tax on all his income. If he were to make no retirement plan contributions through his 401(k) at work, his income on his tax return would be $100,000 and he would pay 20%, or $20,000 in taxes.
“Now, let’s say Bob wants to be savvier when it comes to tax planning. The next year he decides to contribute $20,000 to his company’s 401(k) plan. Since these contributions happen prior to taxes being taken out, he now only shows $80,000 of income on his tax return. He pays his 20% tax on this amount which comes out to $16,000. A whopping $4,000 saved in taxes just by contributing to his 401(k),” Rush explained.
Another advantage of this is that his $20,000 retirement plan contribution can now grow tax-free until he is ready to withdraw those funds in retirement.
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IRA Contributions Count Toward 2023 Income
Even though it’s already 2024, if you have a traditional IRA, “There’s this little window between now and April 15th that if you are looking to reduce your income, you can contribute to a traditional IRA and count it against 2023 income,” said Brian Kearns, CPA, CFP with Haddam Road Advisors.
People aged 50 and under can also make a catch-up contribution of an additional $7,000, and it’s $8,000 for those 50 and older. “So it’s another way to defer income,” Kearns said.
“These additional contributions can further reduce your taxable income, leading to a bigger tax refund today while enhancing your retirement savings,” Kojonen said. “In one scenario, a client was able to use catch-up contributions to not only get into a lower tax bracket but also significantly bolster their retirement nest egg, demonstrating the dual benefits of these strategies.”
SEP IRAs
For small business owners who don’t have an employer sponsored retirement account, you can get a simplified employee pension (SEP) IRA, in which you can defer up to 25% of your net income.
“So if you are a small business owner and you think you’ve had a pretty good year, you could conceivably — even if you don’t have the SEP IRA set up now — you could set it up and count the contribution for 2023,” said Kojonen.
Don’t Let Your Tax Refund Be the Only Reason
Of course, while boosting your retirement savings can generate a higher tax refund, that shouldn’t be the only goal, according to Nathan Jacobs, senior researcher at The Money Mongers.
Contributions to traditional IRAs and 401(k)s are tax-deductible, and while increasing them lowers your taxable income and could increase your refund, there are contribution limits to consider. Jacobs pointed out that your tax refund will hit a ceiling.
“More importantly, the key objective should be having adequate retirement funds. A hefty refund is nice, but retiring comfortably is the real aim. Focus first on saving enough for your future needs, then leverage tax-advantaged accounts to potentially get a refund bonus. But don’t increase retirement contributions solely to enhance your refund — make sure you’re saving smart for your long-term goals,” he said.
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This article originally appeared on GOBankingRates.com: How Increasing Your Retirement Savings Can Get You a Bigger Tax Refund