Choosing a retirement plan that offers the best tax benefit depends on several factors, including your income and the unique tax benefits of each type of plan. Before investing your valuable money in a retirement plan, check which plan will benefit you and fits your unique financial situation.
Tax Benefits of the Best Plans
There are many different types of retirement plans to choose from, but the main vehicles for retirement savings are the traditional individual retirement account (IRA), the Roth individual retirement account, the Simplified Employee Pension (SEP) for self-employed individuals and small business owners, and the 401(k) plan.
Traditional Individual Retirement Account
This account is funded with pre-tax dollars, and earnings grow without tax payment. This means that contributions reduce taxable income during the tax year in which the contributions were made (or at least before filing the tax return for that tax year). Taxes are paid when funds are withdrawn, typically during retirement years.
The maximum contribution for 2021 and 2022 is $6,000. An additional “catch-up” contribution of $1,000 can be made for individuals who are over the age of fifty during the year. There are no income limits for contributions to a traditional individual retirement account; however, there are limits on receiving tax deductions starting at $66,000 for modified adjusted gross income (MAGI) for single filers and $105,000 MAGI for married couples filing jointly in 2021. These limits rise to $68,000 for single individuals and $109,000 for married couples in 2022.
Roth Individual Retirement Account
The Roth individual retirement account is funded with post-tax dollars, and earnings grow without tax payment. You can withdraw contributions only from the Roth IRA without any penalty at any age. At age 59 and a half, you can withdraw contributions and earnings without any penalty, provided the Roth IRA has been open for at least five tax years. The maximum contribution for 2021 and 2022 is $6,000. An additional “catch-up” contribution of $1,000 can be made for individuals who are over the age of fifty during the year. In 2021, you can make a full contribution if your modified adjusted gross income (MAGI) is less than $125,000 and you are filing as an individual. Married couples filing jointly can make a full contribution if their modified adjusted gross income (MAGI) is less than $198,000. These limits increase to $129,000 for single individuals and $204,000 for married couples in 2022.
Simplified Employee Pension for Self-Employed Individuals and Small Business Owners (SEP IRA)
The SEP IRA account is designed for self-employed individuals and small business owners and their employees. The SEP IRA is funded with pre-tax dollars, and earnings grow without tax payment. Withdrawals are taxed at a rate of 10%, just like withdrawals from a traditional IRA. The maximum contribution is the lesser of the salary limit or $58,000 in 2021. This increases to $61,000 in 2022.
401(k) Plan
These employer-sponsored retirement plans are funded with pre-tax or post-tax (Roth) contributions, which grow without tax payment until withdrawal after employment termination. Many employers offer matching contributions when employees contribute their own money through paycheck deductions. The maximum contribution is $19,500 in 2021 and increases to $20,500 in 2022. The “catch-up” contribution for participants who are over age fifty is $6,500 for both 2021 and 2022. The limits do not include matching contributions from employers. An early withdrawal penalty of 10% applies to withdrawals made before age fifty and a half.
Plan
403(b)
403(b) plans are similar to 401(k) plans, as they are employer-sponsored plans with the same contribution limits and matching contribution benefits. Also called tax-sheltered annuities (TSAs), 403(b) plans are typically available through public schools and certain tax-exempt organizations.
Factors that Determine Which Retirement Plan Offers You the Best Benefits
Before deciding which retirement plan offers you the best benefits, the following key factors should be considered:
- Your Income: Generally, individuals with higher incomes benefit more from pre-tax contributions. Conversely, if you are in a lower tax bracket, you may benefit more from Roth contributions. Since traditional and Roth individual retirement accounts have income limits, some individuals may not qualify to contribute. Additionally, you must have earned income to contribute to an individual retirement account. One exception to this rule is when one spouse has earned income while the other does not. The working spouse may be able to make contributions to a spousal individual retirement account.
- Availability of Employer-Sponsored Plans: If you have access to a 401(k) or 403(b) plan and your employer offers matching contributions, you should contribute your own funds, at least to the minimum required to receive the full matching contribution. Individual retirement accounts do not have the matching contribution feature.
- Small Business Owners: If you own a business with a few employees or have no employees, you may have more options for retirement plans for yourself and your employees.
Conclusion
Saving for retirement in a tax-advantaged retirement plan is almost always a good idea. When capital and earnings are not taxed, the benefits of compounding in investments become more powerful.
Source: https://www.thebalancemoney.com/retirement-plans-that-offer-tax-benefits-4584293
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