When faced with the array of accounts for retirement savings, it is important to understand the differences between (1) tax-deferred accounts, (2) taxable accounts, and (3) retirement and savings plans which offer tax advantages. For your situation, the ideal tax-optimization strategy may be to maximize contributions to tax-deferred, taxable, and retirement savings plans. We explore the possibilities here:
Many savings goals can be met with tax-deferred accounts. Currently, there are 7 tax-deferred account types, which are primarily used for retirement savings. The accounts currently available are:
401(k) / 403 (b)
These accounts are sponsored by employers, some of which have a matching funds program, up to a specific amount. 401 (k) plans are usually offered by companies, while the 403 (b) accounts (aka tax-sheltered annuity plan) are a type of retirement account that helps in planning for the retirement of certain employees. These include the employees of public-school systems, certain Code Section 501(c)(3) tax-exempt organizations — usually charities or foundations, and certain church ministers. Some people are eligible for an additional 403(b) contribution known as the “special section 403(b) catch-up” or the “years of service catch-up.” This special type of 403(b) contribution is only available to employees who have worked for a qualified organization for 15 years or longer.
Total contribution limits for 2021 are $58,000 total annual 401(k) if you are age 49 or younger and $64,500 total annual 401(k) if you are age 50 or older.
Solo 401 (k)
Sole proprietor businesses can set up their own 401 (k) accounts. The benefit for sole proprietors is that both the business and individual can contribute. The solo business owner can defer up to 100% of earned income, up to the limit of $19,500 currently, or $26,000 if at or over the age of 50. The total solo 401(k) contribution limit is up to $58,000 in 2021. There is a catch-up contribution of an extra $6,500 for those 50 or older.
Individual Retirement Account (IRA)
IRA accounts are tax-advantaged retirement savings vehicles. You are allowed to withdraw money without penalty at age 59 1/2. If you need to withdraw from your IRA prior to retirement, you’ll pay income tax as well as an additional 10% tax penalty on early distributions if you withdraw the money before you reach age 59 1/2. Contributions to an IRAs can only be made from what the IRS determines to be “earned income” or taxable compensation. Your ability to deduct IRA contributions depends on how much you earn, whether you or your spouse are currently contributing to other qualified retirement plans, and what type of IRA you have. Check with your tax advisor. Typically, you are required to take withdrawals from an IRA when you reach 72. The IRS wants its tax money! The penalty for not taking required minimum distributions is a tax of 50% on any amounts that were not withdrawn in time.
The Simple IRA is for employers with fewer than 100 employees. It offers a reduced paperwork and administrative burden on everyone and currently caps out at $13,500, or $16,000 for employees over 50 years of age.
Small businesses and self-employed individuals also can set up a SEP IRA to save for retirement. Employers are currently limited in their contributions to the lesser of (1) 25% of the employee’s compensation, or (2) $58,000.
Roth IRAs are tax-free accounts that allow you to save using after-tax money. You can withdraw contributions anytime, tax- and penalty- free. However, if you take a distribution of Roth earnings before you reach 59 ½ and before the account is five years old, the earnings may be subject to taxes and penalties depending on what the distribution is used for. In order for an individual to contribute to a Roth IRA, they must have a modified adjusted gross income (MAGI) less than $140,000 for the tax year 2021. If married/filing jointly, your joint MAGI must be under $208,000 for tax year 2021. You can also roll over a Roth 401(k) into a Roth IRA with no income limits.
Health Savings Accounts
Health Saving Accounts (HSAs) allow you to set aside money on a pre-tax basis to pay for qualified medical expenses. You may be able to lower your overall healthcare costs by using pre-tax funds for such things as coinsurance, deductibles, and copayments. Any interest or earnings in the account are also tax-free when paying for qualified medical expenses.
Currently, the HSA contribution limits for individual “self-only” coverage can contribute up to $3,600. If you have family coverage, you can contribute up to $7,200.
A taxable account is a non-retirement account that is funded with after-tax dollars. These include brokerage accounts, bank savings and checking accounts, money and market accounts. “Taxable” means that any increase in income (interest or dividends), or any realized gain from the sale of a security in the account (capital gain) is taxed in the year your taxable account receives them. Taxable accounts do not have limits on contributions or withdrawals, unlike the tax-advantaged accounts.
Retirement Savings Plans
Many of the accounts listed above as “tax-deferred” are useful as retirement savings plans. However, there are others that you should know about as well.
Payroll Deduction IRAs
These are individual IRAs or Roth IRAs where you can authorize your employer to make payroll deductions and contribute that money to your account. It’s a good form of “forced” retirement savings where you have to “pay yourself” first.
These plans accept discretionary contributions from an employer. There is no legally prescribed contribution from the employee. The contributions can be made one year and not the next, depending on situations for both the employer and employee. The business does not have to make a profit to make contributions to a Profit-Sharing Plan.
Money Purchase Plan
Money purchase plans characteristically differ from profit-sharing plans in that unlike the profit-sharing plans, the annual contribution from the employer and/or the employee is defined upfront. It is normally a percentage of compensation for each employee, deposited in their individual accounts. The contribution limit for employers and/or employees is currently the lesser of 25% of employee compensation or $58,000. This limit amount is adjusted for inflation each year.
Defined Benefit Plans
In recent history, the defined benefit plan has become scarce, as companies have either had difficulty funding the plans or have switched over to employee and employer funded 401(k) plans. A defined benefit plan provides a fixed benefit for an employee
s at retirement. There is a value (obviously) to the reliability of a pre-determined, fixed benefit. Employers’ tax-deductible 401(k) contributions to employee accounts can allow for more to be set aside each year than in a defined contribution plan. Defined benefit plans are also typically more complex, and therefore more costly to establish and maintain versus other types of plans.
Employee Stock Ownership Plans (ESOP)
The ESOP is a section 401(a) qualified defined contribution plan in the form of a stock bonus plan. These plans primarily invest in the securities of the employer (if a publicly traded company).
Governmental 457 Plan
A governmental 457 retirement plan is similar to a 401(k) retirement plan except that it benefits the employees of the U.S. government and its agencies, states, or other political subdivisions (cities, counties, etc.), or an Indian tribal government. Governmental plans are employer-sponsored retirement plans allowing dollar or percentage-based contributions from the government employer, the employee, or both. The sponsoring employer provides the eligibility rules and/or vesting schedule. Governmental 457 plans feature a double limit catch-up provision that 401(k) plans do not have. This provision is designed to allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so. In 2021, this provision would allow an employee to contribute up to $39,000 to a plan.
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.