Retirement accounts are the first step in the tax-reduction arsenal. There are not many strategies that can produce a 10 out of 10 effect with only an effort of 1 out of 10.

We will focus on why contributing to retirement accounts can have such power in reducing your taxable income.

The best part about this simple strategy of contributing to retirement accounts is that you are simply moving your money to a different bucket.

Basically, the IRS says, “if you keep your paycheck in your checking account, you owe us taxes. If you move part of your paycheck to your retirement account, we won’t make you pay taxes on it.”

The reason the IRS gives this “break” is because they don’t want the responsibility of taking care of you in your golden years. If the government can encourage you to save for your retirement, you won’t need the government to provide for you. It is cheaper for them to give you a tax break than to provide you housing and food assistance when you retire.

Contributions to employer sponsored retirement accounts (401k, 403b, 457b) are deductions that occur immediately when you are paid. Unless you choose a Roth option, these are pre-tax deductions from the earnings on your paycheck.

Your employer withholds taxes on your paycheck based on how much money you earned in that period. Contributions to retirement accounts reduce the amount of taxes owed in this calculation, effectively lowering the taxes withheld on each paycheck.

For example, if you earned $12,000, your employer may withhold $2,640 for taxes.

But, if you take part of your paycheck, let’s say $1,000 of your $12,000, and put it in your 401k, you will only have taxes withheld based on $11,000 of earnings. Now, the taxes withheld may only be $2,200. It is only $440 in tax savings on this check, but that is likely to add up to more than $5,000 in tax savings by the end of the year.

Without contributing to the retirement account, you would have been giving $5,000 of your hard earned money to the government via taxes. By simply, moving it from your checking account to your retirement account, you saved $5,000, without working any harder.

Doing this over 15 years, that simple $5,000 will turn into more than $200,000 with a 10% return.

Plus, you now have money in a retirement account this is able to be invested to make you even more tax free money. Let’s say that you contribute $1,000 on 20 paychecks per year. If you did that for 15 years at 10%, you would have $696,261, plus the $200,000 from your the compounding effect of your tax savings!

If retirement accounts are so easy and effective, what are the downsides?

The IRS puts certain restrictions on these funds:

You can only contribute a certain amount per year as determined by the IRS.
You can’t withdraw your earnings until a specific age.
You are stuck investing with the providers that your employer allows.

These restrictions are always subject to change so we do not provide details, but you can learn more about the specifics on the IRS website.

There are more effective ways to reduce taxes, and some of the advanced strategies make this one less appealing. But, for the beginner who just wants to take a few steps towards tax savings, this is the easiest option that produces effective results.

More advanced strategies would include:

1. Self-Directed IRAs and 401ks

2. Investing in real estate for depreciation.