In Chapter 2, The Federal Income Tax Return, we learned about the taxability of income from retirement plans. In this chapter, we will discuss the deductions and other tax savings that are available by saving for retirement.

Retirement plans are often described as defined benefit or defined contribution plansdefined contribution planRetirement plan where the amount being contributed into the plan is known, but the benefits depend on the plan earnings over time.. A defined benefit plandefined benefit planRetirement plan where the benefit that the recipient will receive can be computed using the factors of age, number of years working, and income level. provides the recipient a set amount of income that is computed based on the recipient’s age, number of years worked, and income level. An employee can look at those factors in advance and determine the amount of retirement income that will be received. A defined contribution plan does not have that certainty. Instead, the amount that is being contributed by the employer and/or employee is known, but the amount that will be received at retirement depends on the amount contributed and earned over the years.

Qualified retirement plans are available through employers. Tax law provides taxpayers and their employers with an incentive to plan for retirement. Under the tax law, favorable tax treatment is given to contributions, by or for employees, to qualified retirement plans. Employers may claim a deduction in the current year for contributions to qualified retirement plans on the employees’ behalf, while the employees do not include the employer contributions in income until the contributed amounts are distributed. Earnings on the amounts contributed to the plan are also deferred. This deferral of income taxation is a significant benefit to most taxpayers.

Taxpayers contributing to a qualified plan through their employer will not have an adjustment on their income tax return. Instead, on the W-2 the employer furnishes, the amount contributed by the employee will have been deducted from the amount of income that is reported as taxable.

There are many kinds of qualified retirement plans including pension plans, profit-sharing plans, stock bonus plans, employee stock ownership plans, and Section 401(k) plans. A 401(k)401(k)Type of tax advantaged retirement plan. plan often permits the employee to receive compensation in cash or to defer part of the income and invest it in a structured plan. The maximum percentage an employee can defer is 15% or a maximum of $15,500 ($20,500 for an employee 50 or older) and the amounts are reduced if the employee participates in other tax sheltered plans.

Individual retirement accounts (IRAs) often result in a tax deduction. Taxpayers do have the opportunity to invest in other retirement vehicles like IRAs, which can result in a tax deduction. There are three types of IRAs but only one is deductible. The three types are:

It is important to understand that IRAs are savings plans through which funds are invested—IRAs are not a specific investment. An IRA can be placed in a certificate of deposit with a bank, in an account with a mutual fund company, which then invests in equity or bond investments of corporations, or they can be deposited with a brokerage firm and directly invested in stocks and bonds and other financial instruments. The IRA, when established, will be designated as a “traditional” or “Roth” IRA.

From a financial planning perspective, IRAs are one of the best vehicles for individuals to save money for retirement and can often be used to save taxes. No matter which IRA is used, the earnings on the account are tax free until withdrawn. A traditional IRA provides an immediate tax deduction as a deduction for AGI and funds, when withdrawn, are taxable. Deposits to a Roth IRA do not create an immediate deduction, but all withdrawals at retirement are tax free.

Each type of IRA has limitations in the amounts that can be deposited. Tables 17-1, 17-2 and 17-3 in Publication 17 provide information on the phaseout of the IRA deduction based on a modified adjusted gross income, whether the taxpayer is in another retirement program with an employer, and age. The amount of the deduction is calculated using the IRA Deduction Worksheet included in the 1040 instructions. Another way to compute the amount of the deduction is to use the following formula:

For a traditional IRA, the maximum deductible contribution is $5,000 or $6,000 if age 50 or older.