4 tax tips to consider early in your career

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When you're building your career in your 20s and 30s, it's important to invest using tax-efficient strategies. Consider these tips for trimming your taxes.
Retirement may seem far away early in your career, and the kinds of tax-efficient strategies that can help you reach such an important long-term goal may not be top of mind. But the younger you are when you start investing, the more time your money has to grow.
The reason for investing as early as possible comes down to the power of compounding. Any savings you invest while you're young have far more potential to grow than the money you invest later in life. In fact, as the chart below shows, investing even a small amount in a retirement account over a long period of time can have a greater impact on your results than investing a larger dollar amount for a shorter period.
Of course, finding extra money to save so you can enjoy the benefits of compound growth can be a challenge. That's where tax planning can help. By taking advantage of tax-qualified retirement plans, you can reduce your taxable income and save on federal (and possibly state) taxes, potentially allowing you to put more money toward your long-term financial goals.

Starting to invest early on — even just a small amount — may help you in retirement

By starting to put away money earlier, a 25-year-old investing $200 per month ($2,400/year) accumulates more assets by age 65 than if he or she had started to invest $300 per month ($3,600/year) at age 35 — despite investing less each period.
Value of retirement contributions by age 65. If you save $200 a month starting at age 25, you could have $638,300 by age 65. If you save $300 a month starting at age 35, you could have $427,400 by age 65.
This assumes an average annual nominal return of 7.8%.
Source: Chief Investment Office. This example is hypothetical and does not represent the performance of a particular investment. Results will vary. Actual investing includes fees and other expenses that may result in lower returns than this hypothetical example.
Even if you can't save as much as you'd like in a retirement account right now, remember to continually look for opportunities to increase your contributions so you can give your investments as much time to grow as possible. Consult with a tax advisor and consider these four strategies for trimming your taxes and saving more.

1. Revisit the amount of taxes taken from your paycheck

One way to free up money to save is to Go to third-party website recalculate the amount of taxes you're having withheld popup from your paycheck. If you're expecting a significant tax refund this year, consider reducing your withholdings to increase your take-home pay. After all, when you get a tax refund, it's as if you'd made an interest-free loan to the government.
Set up direct deposit to put the extra money directly into an investment or savings account or raise your contributions to a workplace retirement plan.
TIP
Any time you get a raise at work or receive a bonus or other windfall, consider earmarking at least part of that boost to your income for retirement investing.

2. Contribute to tax-qualified retirement accounts

Saving money in a tax-qualified retirement account offers two potential tax benefits. First, the contributions you make to a traditional 401(k) account (or other employer-sponsored retirement plan) or deductible contributions you make to a traditional IRA could lessen your tax burden by reducing your taxable income. Any tax savings can be turned into extra money to invest.
Second, because any growth in a 401(k) or an IRA is generally tax deferred, the power of compounding over time is enhanced. Maximizing your contributions to retirement accounts while you're young is a smart move, especially if your employer matches part of those contributions.Footnote 1
Here's how the tax treatment of the major types of tax-qualified retirement accounts differs. There are limits for how much you can contribute to each type of tax-qualified retirement account every year. You can view the most current 401(k) and IRA limits here (PDF).
Account Upfront tax treatment Grows tax-deferred? Taxes on withdrawals
Traditional IRA Contributions are generally tax deductible if your modified adjusted gross income (MAGI) does not exceed certain limits, which vary based on your filing status and whether you or your spouse are covered by an employer-sponsored retirement plan (such as a 401(k) plan). X Generally, withdrawals in retirement are taxed at your then-current federal ordinary income tax rate.
Traditional 401(k) Contributions are made on a pre-tax basis, reducing your taxable income by deferring taxation until retirement. X Generally, withdrawals in retirement are taxed at your then-current federal ordinary income tax rate.
Roth IRA Contributions are not tax deductible. X Withdrawals are federal income tax-free if the requirements for a "qualified distribution"Footnote 2 are met.
Roth 401(k) Contributions are made with income that's already been taxed. X Withdrawals are federal income tax-free if the requirements for a "qualified distribution"Footnote 2 are met.
State tax treatment is generally similar, but can vary. Consult your tax advisor.

3. Spread your savings among different types of accounts

Down the road, when you retire and finally start drawing income from your savings, those withdrawals may be treated differently for tax purposes, depending on the type of account. For that reason, the decisions you make today about where to save for retirement could potentially help you save on taxes decades from now.
You don't know whether your tax rates in retirement will be higher or lower than they are now. But by funding a variety of accounts, you'll be able to mix and match income sources later, such as choosing between fully taxable withdrawals from traditional 401(k) accounts and traditional IRAs and tax-free distributions from a Roth 401(k) and Roth IRA.
If you're earning enough to save beyond your 401(k), consider investing in a taxable investment account (like a brokerage account). The tax treatment is different — and can give you more flexibility when you retire. A tax advisor can help you understand your options.
TIP
Later in your career, your MAGI may exceed the limits for Roth IRA contributions. So it may be worth thinking about contributing to a Roth IRA early on while you still may qualify.

4. Match investment selections with the right account type

Some types of investments are more tax efficient than others. Once you have savings in both tax-qualified retirement accounts and taxable accounts, the decisions you make about what kinds of stocks, bonds, mutual funds and exchange-traded funds to hold in each can affect how much you may owe in taxes every year. This is an important consideration for younger investors because even small differences can add up and compound over time. Consider these possible moves:
  • Investments that regularly generate taxable income, such as taxable bonds or stock funds that turn over their holdings frequently and distribute a large amount of income to shareholders, may be better held in tax-deferred retirement accounts — traditional IRAs or other retirement plan accounts, for instance. That way, you won't pay taxes now.
  • Investments that limit tax burdens, such as tax-managed mutual funds that minimize distributions of capital gains and dividends, exchange-traded funds, and individual securities (including municipal bonds), are better suited for nonretirement accounts.
Keep in mind that decisions about where to hold various securities should be consistent with your overall financial strategy.
As you consider these tax-saving strategies, remember it's never too soon to think about saving for retirement. And it's a good idea to discuss any moves with your tax advisor.

Next steps

Footnote 1 Taxes may be due upon withdrawal, depending on account type.

Footnote 2 A "qualified distribution" is generally one that is taken at least five years after the first day of the year of ‎your initial Roth contribution or Roth conversion if earlier and after you have reached ‎age 59½ or become disabled or deceased. If you take a non-qualified withdrawal from your ‎Roth 401(k) account or Roth IRA, any investment earnings on the Roth contributions are subject to ‎regular income taxes, and you may be subject to a 10% additional federal tax unless an exception applies. State income tax laws vary; ‎consult a tax professional to determine how your state treats distributions from Roth 401(k) accounts or Roth IRAs.‎‎

Diversification does not ensure a profit or protect against loss in declining markets.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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