There’s no one perfect way to approach retirement that is the best for everyone. Choosing the right plan for you starts with understanding your options and the tax implications of each one.
There are several different approaches you can take to your retirement savings strategy. Each avenue has its own set of tax implications and benefits. And without a thorough look at what’s out there, you’ll never know whether you’re choosing the option that meets all your needs and sets you up for optimal tax minimization.
Let’s dive deeper into:
- The most common retirement plan options and their tax implications
- How to make the right choice for your situation
Retirement plan options
Traditional 401(k) or 403(b)
These retirement accounts are very common and have benefits for both employees and employers. In many cases, an employer matches the employee’s monthly contributions and receives tax breaks on those contributions.
The most significant difference between a 401(k) and a 403(b) is that nonprofit organizations use the latter. Otherwise, they generally have the same pros and cons.
Some employers offer both Traditional and Roth 401(k) plans. A Traditional account provides tax savings now since contributions are made pre-tax. In contrast, the Roth allows investors to avoid taxes when they’re in retirement, as the contributions have already been taxed.
The contribution limit for a 401(k) is $19,500 annually, and $26,000 if you’re over 50.
Defined benefit plans
The aforementioned 401(k) plan is considered a defined contribution plan. Defined benefit plans, also known as pensions, are retirement accounts where only the employer makes contributions.
Workers with a pension know in advance how to calculate the benefits they’ll receive in retirement, whereas defined contribution plans are dependent upon investment returns. Pensions don’t give the recipient any control, and they usually have to meet vesting requirements, but they are not responsible for making contributions.
A good option for a small business owner or self-employed worker with zero employees is the Solo 401(k) plan. You can contribute up to $57,000 or 100% of your income, whichever is less. Just like an employer-sponsored 401(k), contributions are made pre-tax, so you see the tax benefits now, rather than later.
Although you can’t have employees with a 401(k), you can hire your spouse for your business, and they can also contribute to the plan.
Traditional and Roth IRAs
A payroll-deduction IRA is often offered to employees when an employer doesn’t offer a retirement plan. Only employees make contributions to these accounts. But individuals can also set up IRAs either in addition to their employer plans or if self-employed.
The two types of IRAs to know about are Traditional and Roth IRAs:
- Traditional IRA: You contribute pre-tax dollars, so you pay taxes in retirement but defer them for now. These are best for individuals who expect to be in a similar or lower tax bracket in retirement.
- Roth IRA: You pay tax now on contributions, so withdrawals are tax-free. This is a good option if you think you’ll be in a higher tax bracket when you start withdrawing, thus avoiding that higher tax rate.
Both of these types of IRAs have a maximum annual contribution limit of $6,000, or $7,000 if you’re over 50.
A Simplified Employee Pension (SEP) plan is a good plan for small business owners, either with no employees or just a few. You can contribute $57,000 or up to 25% of compensation, whichever is less, and you can deduct contributions on your tax return. But as with a traditional IRA, income you receive in retirement is taxed.
These IRAs are best for owners of larger businesses with 100 or fewer employees. You can contribute up to $13,500, plus a catch-up contribution of $3,000 if you’re 50 or older. Total contributions for this plan and an employer plan, if applicable, have a limit of $19,500.
SIMPLE IRA contributions are tax-deductible, and account holders pay tax on the income in retirement. If an employer makes contributions to employee SIMPLE IRAs, those are deductible as a business expense.
Choosing the right option for you
Now that you know the basics about these common plans, how do you make the right choice? Here are a few pertinent questions to think about:
- Are you likely to be in the same or lower tax bracket when you retire? Higher? A Roth retirement account allows you to pay taxes now, so if you’re in a lower bracket now and expect to be pushed to a higher one later, this may be a good option.
- Are you self-employed? How big is your business? Do you have any employees or plan to?
- How much do you want to save each year for retirement? Each has its own limits.
- Does your employer offer a retirement plan? This will determine how many options you have.
Identifying your priorities will help you weigh each retirement account’s pros and cons and find the plan that gives you the right balance of tax benefits and savings.
Working with tax professionals
When you need assistance selecting the right tax-advantaged strategy, work with the experts who can run the numbers for you. The team at Provident CPA & Business Advisors will help you plan for a more prosperous future and explain all tax implications of the different options available to you.
Contact us today to get started.