Geoffrey Rosen, CEBS, AIF®, CPFA
Which retirement plan is right for you — and how can you utilize that plan as a tax-savings strategy?
The answer depends on several factors: employment status, the types of plans an employer offers, contribution and deduction limitations, and more. Here is a comprehensive list of retirement savings accounts, as well as the benefits and limitations of each.
IN THIS ARTICLE:
- Determining the right tax-saving strategy for you will depend on when your taxes are enacted, whether upfront as you contribute to your account or once the funds are withdrawn (typically at retirement).
- All contributions to Roth accounts are taxed upfront, which both guarantees tax savings in the future when funds are withdrawn and means that all investment earnings over the life of the account are non-taxable.
- The type of retirement plan that’s a right fit for an employer/business owner will depend on the type of business and cash flow.
Types of Retirement Plans and How They’re Taxed
First, consider what distinguishes the different types of retirement plans. Factors include:
- Timing of when taxes are paid (pre-tax versus after-tax, or Roth)
- Who can contribute to the account
- Monetary limits on annual contributions
- Limits on deductions
- Other requirements and/or qualifications
Timing of Taxes
A retirement plan is either pre-tax or after-tax (Roth).
Pre-tax Plans: Taxes are Deferred until Withdrawal
For these plans, you receive an immediate tax break and instead pay taxes on the withdrawals you make from the account at retirement.
- 401(k)
- Solo 401(k)
- Safe Harbor 401(k)
- Traditional IRA
- Profit Sharing Plans
- Cash Balance Plans
After-tax Plans: Taxes are Paid Upon Contribution
The funds contributed to these plans have already been taxed. Therefore, neither funds withdrawn in retirement nor investment growth earning will be taxed.
- Roth IRA
- Roth 401(k)
- Backdoor Roth IRA *
* With the exception of when you initially convert your traditional IRA to a Roth IRA.
A Breakdown of Each Retirement Plan
401(k):
What is a 401(k)?
A Traditional 401(k) Plan is a pre-tax employee retirement savings plan offered through an employer.
Who is it for?
This plan is a popular employer-sponsored savings program provided as a benefit to full-time employees.
What are the benefits?
Employers provide full-time employees the ability to fund their own retirement accounts on a pre-tax or Roth after-tax basis. Contributions are fully vested. Employees can elect to defer up to $20,500 into the plan, and those aged 50+ can even make a special catch-up contribution. In addition, employers can choose to match employee contributions and even receive a tax deduction for matching contributions.
What are the limitations?
There is a 25% deduction limit for employer contributions, excluding deferrals, and the ADP (Actual Deferral Percentage) test may limit highly compensated employee deferrals.
SOLO 401(k):
What is a Solo 401(k)?
A solo 401(k) plan is a retirement savings plan for owner-only businesses, whether incorporated or unincorporated.
Who is it for?
This type of retirement plan is for businesses with only one owner. Spouses and partners in a partnership can also be included.
What are the benefits?
As the owner, you can choose the amount of contributions you make from year to year. You can also take loans of up to 50% of vested balances (up to $50,000), as well as consolidate balances from other plans, including rollovers from IRAs and other qualified plans.
What are the limitations?
There is a 25% deduction limit, as well as setup fees and ongoing administrative costs.
Profit Sharing Plans
What is a Profit Sharing Plan?
A Profit Sharing Plan is a pre-tax retirement plan used by employers when they need tax deductions and want to provide equal contributions to all employees.
Who is it for?
Employers and owners of any size business can provide employees with a share of the business’s profits using this type of profit-sharing plan, which is particularly beneficial for businesses where cash flow may be an issue.
What are the benefits?
Profit sharing is a way for employers, particularly small business owners, to provide retirement savings options. This plan in particular is incentivizing, as it involves the employees more directly. There are also tax advantages, as it’s deductible for the business and not immediately taxable to the employees.
What are the limitations?
Only employers contribute to the employees’ accounts, and there are penalties applied when funds are withdrawn early.
Cash Balance Plans
What is a Cash Balance Plan?
A Cash Balance Plan is a type of pension plan with a defined benefit to eligible employees at retirement. The employee’s account is credited each year with a “pay credit” from the employer and an “interest credit” (at either a fixed or variable rate), and investments are managed professionally.
Who is it for?
This plan is for employers with high, steady incomes.
What are the benefits?
The risks are low for employees. In fact, the investment risks are managed by the employer, and the account does not depend on the worker’s contribution of part of their compensation. If employees do contribute, the limits on those contributions increase with age. At retirement, employees can opt to receive their benefits in a lump sum of the total cash balance or as a lifetime annuity.
What are the limitations?
There are higher administrative costs associated with Cash Balance Plans.
Roth IRA
What is a Roth IRA?
A Roth IRA is an independent retirement account where contributions have already been taxed.
Who is it for?
This type of plan is for employees with an earned income whose employers do not contribute to their retirement savings.
What are the benefits?
Because contributions are taxed upfront, employees will not pay taxes on any investment earnings made from year to year, and the funds withdrawn in retirement will not be taxed. Unlike a 401(k), you are not required to make withdrawals from your Roth IRA account in retirement, and you can withdraw funds without penalty if the account is at least 5 years old.
What are the limitations?
There are limits to the amount a person can contribute to a Roth IRA, but those limits tend to be lower than for 401(k) plans.
Backdoor Roth IRA
What is a Backdoor Roth IRA?
A Backdoor Roth IRA is a strategy for reducing taxes rather than an actual retirement plan. This strategy allows a person to roll over a traditional IRA and convert it to a Roth IRA without being hindered by income and contribution limits.
Who is it for?
This type of plan is typically for people earning a higher income who want to contribute more to their retirement savings account.
What are the benefits?
All future earnings on the account and any future withdrawals from it will not be taxed. However, when you convert the funds in your traditional IRA to a Roth IRA, all assets in the IRA that were not previously taxed (including the principal amount and any earnings and appreciation) will be taxed. Once the transition is completed, your new account will no longer be affected by any income and contribution limits.
What are the limitations?
When first establishing the Roth IRA, you will owe taxes on the funds in your traditional IRA — potentially a large amount, depending on the balance of the IRA.
Get help selecting the retirement savings plan that best suits your needs.
When you’re uncertain of your retirement plan options, you could be missing out on setting yourself up for success in retirement — and valuable tax savings. Work with a Landmark Financial Planner to ensure you understand all of the plans available to you and select the one(s) that best suits your needs.