Investing your hard-earned money in the right tax-advantaged retirement account can make all the difference when it comes to meeting the financial goals you’ve set for your golden years. There are two broad categories of tax-advantaged retirement accounts—those that are “tax deferred” and those that are “tax free.” Tax deferred accounts allow you to make tax-deductible contributions and defer taxes on those contributions plus any investment gains until you make withdrawals, at which point withdrawals are taxed as ordinary income. Tax free accounts are funded with after-tax dollars, and earnings and withdrawals in the future are tax-free.
Protecting your funds from taxation while they are in the account sounds like a major win – but how do you tell which retirement savings accounts will get you the most bang for your buck?
An essential part of financial planning is determining the right type of tax-advantaged retirement account for your situation. While some investors are limited to their company’s or organization’s 401(k) or similar offerings, the self-employed or those running small businesses have other retirement planning options.
Here are the pros and cons of various tax-advantaged retirement accounts:
Earnings in a traditional IRA are tax-deferred until the owner withdraws funds after retiring. At that point, it is likely, but not always the case, that the account owner is in a lower tax bracket than during their working years. If the account owner has no employer-sponsored retirement plan, and if they’re married and their spouse doesn’t either, they can deduct their traditional IRA contributions on their federal income tax return up to certain statutory limits. Those covered by a retirement plan at work may be subject to limitations on the tax deductibility of their IRA contribution based on their income.
For 2023, the maximum traditional IRA contribution is $6,500 for those under 50, and $7,500 for those 50 and up.
A Simplified Employee Pension plan (SEP-IRA) is commonly used by self-employed, single-person businesses. SEP-IRAs allow employers to contribute to a traditional IRA. For 2023, the maximum contribution is 25 percent of each employee's pay, contributed by the employer, up to a limit of $66,000. Many employers contribute pre-tax to take advantage of the tax deduction, but the SECURE Act 2.0 recently allowed sponsors of SEPs to offer employees the ability to designate contributions as Roth contributions.
A Savings Incentives Match Plan for Employees (SIMPLE) can be implemented by employers with a hundred employees or less. For smaller companies, this can be a convenient retirement plan to set up. On the downside, a SIMPLE IRA’s employee contribution limit is lower than that of a 401(k).
A self-directed IRA generally involves alternative assets, such as:
Self-directed IRAs allow you to invest in assets outside of stocks and bonds. These assets are usually illiquid and riskier. When investing in real estate through a self-directed IRA, keep in mind you won’t receive any of the tax deductions available in standard real estate investing. Also, when the time comes to take required minimum withdrawals, holding illiquid assets in an IRA can be a nuisance.
A Roth IRA can offer long-term tax benefits. Unlike a traditional IRA, you are not required to make withdrawals upon reaching a certain age. You don’t pay taxes on withdrawals because the initial contributions are made with after-tax dollars. However, there are income limits for eligibility. For 2023, only single filers with a modified adjusted gross income (MAGI) of up to $138,000 and married couples filing jointly with a MAGI of up to $218,000 can contribute the full amount to a Roth IRA.
Annual contribution amounts for a Roth IRA are the same as for a traditional IRA. You cannot deduct Roth IRA contributions from your income tax as they were made with post-tax dollars.
For those earning more than the income limits, they may consider making a non-deductible IRA contribution and then converting to a Roth IRA. This is referred to as a “backdoor Roth.” However, it’s important to be aware that Roth conversions can count as taxable income if non-deductible contributions are commingled with pre-tax contributions in a Traditional IRA. This is why it’s important to work with a tax adviser before making a Roth conversion decision.
This is the common plan offered to employees by most employers. Besides the tax-deferred contributions, employers often provide matches based on your contributions. That’s free money! While the match percentage depends on the employer, some companies provide a match of up to 6 percent of your total pay. If you are thinking of leaving your job, make sure to check if your employer’s matching contributions have fully vested. Otherwise, the employer contributions will be forfeited back to the employer if you leave.
For 2023, the 401(k) contribution limit is $22,500 for employees and $66,000 for combined employee and employer contributions. Those age 50 and up can contribute an additional $7,500 in catch-up contributions, for a total of $30,000 in employee contributions, and up to a total $73,500 for combined employee and employer contributions.
Contributions to a Roth 401(k) are made with post-tax dollars. You receive tax-free growth and tax-free withdrawals with a Roth 401(k). Contribution limits are the same as for traditional 401(k)s.
For a self-employed business owner, the solo 401(k) allows the wearing of two hats at once. As an employee, they can max out their employee contribution. As the employer, they can receive a deduction for establishing a profit-sharing contribution. Some business owners choose to create customized Solo 401ks, with the help of a third-party administrator, to allow contributions of post-tax dollars that can be immediately distributed to their Roth IRAs.
A SIMPLE 401(k) has lower contribution limits than a regular 401(k). Only employers with 100 employees or fewer can create a SIMPLE 401(k) for their business.
A safe harbor 401(k) allows for larger contributions from Highly Compensated Employees (HCEs).
There are 3 options for a Safe Harbor 401k.
Non-Elective Safe Harbor – Eligible employees get an annual employer contribution of 3% of their salary. The amount is fully vested, and the employee gets it whether or not they contribute to the plan
Basic Safe Harbor Match – The employer matches 100% of the first 3% of each employee’s contribution and 50% of the next 2%. Employees are required to contribute to get the match.
Enhanced Safe Harbor Match – The employer matches 100% of the first 4% - 6% of each employee’s contribution. Similar to the Basic Safe Harbor Match, employees would need to contribute to qualify for the match.
It is important to work with an experience team to determine which formula would be best suited for your company’s needs.
If you work for a nonprofit organization or educational institution, you are likely contributing to a 403(b) plan. While similar to a 401(k) when it comes to tax deferral, these retirement accounts seldom have a matching component. Investment choices for 403(b)s are generally more limited than that of 401(k)s.
Getting the most out of your retirement accounts requires careful tax planning. That's why you should seek professional advice to ensure you are maximizing your tax-advantaged retirement accounts.
Schedule a portfolio review with a financial advisor at EP Wealth Advisors to determine if you’re on track to meeting your retirement goals.
If you work for a state or local government or a tax-exempt organization under IRC 501(c), you are likely contributing to a 457(b) plan. Like 401(k) plans, contributions to a 457(b) plan, and earnings on the contributions, are tax-deferred.
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