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Retirement accounts should be called “tax-reduction accounts” — if they were, more people would be more motivated to contribute to them. Contributions to these plans are generally deductible for both your federal and state income taxes. Suppose that you pay about 30 percent between federal and state income taxes on your last dollars of income. (See the section “Figuring out your tax bracket” later in this chapter.) With most of the retirement accounts that I describe in this chapter, you can save yourself about $300 in taxes for every $1,000 that you contribute in the year that you make your contribution.

After your money is in a retirement account, any interest, dividends, and appreciation grow inside the account without taxation. With most retirement accounts, you defer taxes on all the accumulating gains and profits until you withdraw your money down the road, which you can do without penalty after age 59½. In the meantime, more of your money works for you over a long period of time. In some cases, such as with the Roth IRAs described later in this chapter, withdrawals are tax-free, too.

The good old U.S. government now provides a tax credit for lower-income earners who contribute up to $2,000 into retirement accounts. The maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $19,500 and married couples filing jointly with an AGI of $39,000 or less (these income ranges are for tax year 2020). Singles with an AGI of between $19,500 and $21,250 and married couples with an AGI between $39,000 and $42,500 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $21,250 but no more than $32,500 and married couples with an AGI between $42,500 and $65,000 can get a 10 percent tax credit. This credit is claimed on IRS Form 8880, “Credit for Qualified Retirement Savings Contributions.”