What do I need to know about retirement contributions for my taxes?

Contributed by: PhillipB, FreeTaxUSA Agent, Tax Pro

There are several options to save for retirement, each with its own tax advantages and rules. Understanding how retirement contributions affect your taxes is important for saving money on taxes now and planning for lower taxes in retirement.

Here are some of the most common retirement contributions:

Employer-sponsored 401(k) or 403(b) plans (Roth and traditional IRA options)
Small employer SEP or SIMPLE IRA plans (Roth and traditional options)
Traditional and Roth IRA contributions
Pensions

Besides being a wise investment for the future, retirement contributions can help reduce taxable income and provide a tax credit for lower income taxpayers. Long term, the type of retirement account(s) you choose to contribute to can help you have tax-free or partially taxable retirement income in the future.

Employer-sponsored plans

The most common employer-sponsored retirement plan is a 401(k). Nonprofit entities (including some governmental agencies and institutions) use 403(b) plans, but the two types of retirement plans are virtually the same in their tax benefits and participation rules. Contribution limits for 401(k), 403(b), and other less common employer retirement plans can be found on the IRS website.

Contributions to traditional employer retirement plans reduce taxable federal and (in most cases) state wages on employee W-2s. All contributions to employer-sponsored retirement plans are reported on employee W-2s in box 12, with specific codes for each type of retirement plan.

Most employer retirement plans offer a traditional retirement option and a Roth retirement option. Employees can choose to contribute to either or both types of retirement plans, as long as the total contributions don’t exceed the limits.

Taxpayers don’t need to report their contributions to employer plans anywhere on their tax return besides what is reported on their W-2s.

Traditional and Roth IRAs

The most used retirement accounts are individual retirement accounts (IRAs). Anyone can contribute to an IRA, regardless of age, if they have taxable earned income. Earned income is generally from working a job or being self-employed.

Contributions to an IRA and employer retirement plan can be made in the same year. The combined limit for all IRA contributions is the lesser amount of either the standard annual limit or the taxable earned income for the year. Contribution limits for IRAs can be found on the IRS website.

Contributions to a traditional IRA can be deducted on your tax return, unless you exceed certain income limits. If the income limits are exceeded, contributions can still be made but can’t be deducted on your tax return. They become nondeductible IRA contributions. See related articles: What are nondeductible IRA contributions? and What is an IRA basis and why is it important?

Taxpayers can only contribute to a Roth IRA if their modified adjusted gross income (MAGI) is below certain thresholds. Limits for the current and prior tax years can be found by visiting the IRS website and clicking the links labeled “Amount of Roth IRA contributions you can make.”

The amount you can contribute is reduced as your income exceeds the threshold, until it’s completely phased out. If a taxpayer makes Roth IRA contributions that are phased out due to income limits, they’ll have excess contributions that are subject to a 6% penalty unless they’re withdrawn or recharacterized as traditional IRA contributions before the deadline of the tax return.

Since IRA contribution limits are tied to MAGI reported on your tax return, FreeTaxUSA software will ask very detailed questions about traditional IRA and/or Roth IRA contributions made during the year. To report IRA contributions, follow menu path: Deductions / Credits > Common Deductions / Credits > IRA Contributions.

If traditional IRA contributions aren’t deductible because of income limits, nondeductible contributions are reported to the IRS on Form 8606. If Roth IRA contributions aren’t allowed or are reduced because of income limitations, the excess contributions are reported to the IRS on Form 5329.

What do I do if I have excess contributions?

There is the risk of having excess contributions to employer-sponsored plans and Roth IRAs even if you didn’t make glaring errors in completing your onboarding payroll documents at work. Excess contributions can happen due to errors or miscommunications about contribution amounts or other changes handled by your IRA custodians.

Excess 401(k) contributions usually happen when there’s a change of employer during the year and the combined 401(k) contributions from all employers exceed the total limit. When this happens, contact the employer’s retirement plan administrator to have them return the excess contribution to you as soon as possible. Form 1099-R will likely be issued reporting the distribution of the excess contribution. The timing of your excess contribution correction will determine how you report the distribution on your tax return.

Excess traditional IRA contributions are rare and usually only happen when a taxpayer contributes more than their compensation (usually this is earned income. If you have an excess traditional IRA contribution, withdrawing the amount and any earnings on the contribution is likely the best option. Since an IRA deduction wouldn’t be available in this scenario, the only taxable income from withdrawing an excess traditional IRA contribution would be the earnings. If the excess is not withdrawn, the 6% excise tax would apply to the contribution each year until the excess amount (plus earnings) is withdrawn.

Excess Roth IRA contributions are more common, and you have a few options for dealing with it:

Withdrawal of the excess contribution by the deadline of the tax return (this includes extensions, if filed)
1. Earnings on the excess contribution will be taxable.
2. If you’re under age 59 1/2 when the earnings are returned to you, the taxable amount will be subject to the 10% early withdrawal penalty.
Recharacterize the excess Roth contributions to be a traditional IRA contribution
1. The excess Roth contribution becomes a nondeductible traditional IRA contribution.
2. If you’ve never made traditional IRA contributions and don’t wish to now, you can convert the traditional IRA to a Roth IRA tax-free through a “backdoor Roth conversion”.
Apply the excess contribution to next year’s Roth IRA contribution
1. Simply report the excess contribution and pay the 6% penalty on your tax return for the current year.
2. Make sure to reduce money you contribute for the next tax year by the amount of your excess contribution.
3. There is a risk of having income that’s too high to contribute in the next tax year. If that’s the case, consider one of the other two corrective options.

Key takeaways

Retirement contributions are an important part of most people’s short- and long-term financial plans. Consider consulting with a financial professional to plan the best way to ensure your financial needs are met when you retire. We’re here to help you handle tax issues related to your retirement contributions along the way.

Additional Links:

What do I do if I never filled out Form 8606 for past nondeductible IRA contributions?

What is the pro rata rule and why do I need to know it?

Reporting a Backdoor Roth - Basic Scenario (2024 and later)