Choosing the retirement plan that offers the best tax benefits depends on several factors, including your income and the specific tax benefits of each plan. Before you invest your hard-earned money in a retirement plan, consider which one is better for you and your personal financial situation.
For example, just because a 401(k) plan allows for a higher annual contribution rate, doesn’t mean it’s the best retirement plan for your needs. Additionally, the popular Roth IRA isn’t always the best individual retirement account for people saving for retirement.
The tax benefits of the best retirement plan and how they work
There are many different types of retirement plans to choose from, but the primary retirement savings vehicles are traditional IRAs, Roth IRAs, SEP IRAs, and 401(k) plans.
Here are the key features and benefits of each type of retirement plan.
Traditional IRA
This is funded pre-tax and returns grow tax deferred. This means that the contribution reduces taxable income for the calendar year in which the contribution is made (or at least until the calendar year tax return is filed). Income taxes are paid on distributions (withdrawals), usually during retirement.
The maximum donation for 2021 and 2022 is $6,000. For those 50 or older, an additional $1,000 in “catch-up” contributions are available during the year. There are no income limits for traditional IRA contributions; however, there are caps on receiving tax deductions, starting at $66,000 for 2021 Modified Adjusted Growth Income (MAGI) for single filers and $105,000 for married couples filing jointly. In 2022, the cap will increase to $68,000 for single filers and $109,000 for married couples.
Roth IRA
A Roth IRA is funded with after-tax dollars and grows tax deferred. You can withdraw your contributions from a Roth IRA at any age without penalty. At age 59 1/2, you can withdraw contributions and earnings without penalty, provided your Roth IRA has been open for at least five tax years. The maximum donation for 2021 and 2022 is $6,000. For those 50 or older, an additional $1,000 in “catch-up” contributions are available during the year.
In 2021, you can contribute in full if your MAGI is less than $125,000 and you file as a single. If your MAGI is less than $198,000, married people filing jointly can contribute the full amount. In 2022, the limit will increase to $129,000 for singles and $204,000 for married couples.
SEP IRA
A SEP IRA is designed for self-employed individuals, small business owners, and their employees. It is funded with pre-tax capital and grows tax deferred. As with traditional IRA distributions, withdrawals are subject to a 10% tax. The contribution limit is the lower of the two: 25% of salary, which is $58,000 in 2021. It will increase to $61,000 in 2022.
401(k) plan
These employer-sponsored retirement plans are funded by pre-tax or after-tax (Roth) contributions that become tax deferred until paid by the employer in retirement. Many employers offer matching contributions if employees contribute by deducting their own money from their payroll.
The increased contribution limit is $19,500 in 2021 and increases to $20,500 in 2022. The catch-up contribution for 2021 and 2022 for participants age 50 and older is $6,500. Maximum contributions do not include employer contributions. A 10% early withdrawal penalty applies to distributions made before age 59 ½.
403(b) plan
Similar to 401(k) plans, 403(b) plans are employer-sponsored plans with the same contribution limits and employer matching features. 403(b) plans, also known as tax-sheltered annuities (TSAs), are often available through public schools and certain tax-exempt organizations.
Factors that determine which retirement plan will provide you with the best benefits
Before deciding which retirement plan offers you the best benefits, you should consider the following key factors:
- Your income: Generally speaking, people with higher incomes benefit the most from making pre-tax contributions. The opposite is also true: If you’re in a low tax bracket, you’ll likely benefit the most from a Roth contribution. Because both traditional and Roth IRAs have income limits, some people are not eligible to contribute. Additionally, you must have income to contribute to an IRA. One exception is when one spouse has an income and the other spouse has no income. A working spouse may be able to contribute to a spousal IRA.
- Availability of Employer-Sponsored Plans: If you are entitled to participate in a 401(k) plan or 403(b) plan and your employer provides matching contributions, you should contribute yourself, at least up to the minimum amount, to receive the full subsidized match. There is no matching feature for IRAs.
- Small Business Owners: If you own a business with few or no employees, you may have more retirement plan options for yourself and your employees.
Key Takeaways
Here are the top retirement plans and the people who will benefit the most from them:
Traditional IRA: Ideal for those who want to enjoy a lower tax bracket in retirement than when they contributed, or who need to reduce their current taxable income. In order to be able to contribute, you must have an earning income (or have an earning spouse).
Roth IRA: Best for those who want to be in a higher tax bracket in retirement than when they contributed. In order to be able to contribute, you must have an earning income (or have an earning spouse).
SEP IRA: Ideal for small business owners and self-employed individuals who want a simple way to maximize their retirement savings contributions (which may be higher than other IRA types).
401(k) plan or 403(b) plan: Best for qualified individuals and when the employer provides matching contributions. Also ideal for individuals whose income is too high to contribute to a traditional or Roth IRA. Most 401(k) plans offer traditional or Roth contributions.
In Conclusion
A tax-deferred retirement plan is almost always a good idea. The benefits of compound interest on investments become even greater when capital gains and dividends are not taxed.
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