Choosing a retirement plan that offers the best tax benefit depends upon several factors, including your income and the tax benefits unique to each type of plan. Before investing your hard-earned money in a retirement plan, see which one will benefit you and your unique financial situation.
For example, just because a 401(k) plan allows for higher annual contribution rates doesn't mean it's the best retirement plan for your needs. Also, the popular Roth IRA is not always the best individual retirement account for everyone saving for retirement.
Tax Benefits of Top Retirement Plans and How They Work
Here are the primary features and benefits of each type of retirement plan.
This is funded with pre-tax dollars, and earnings grow tax-deferred. This means that contributions reduce taxable income during the calendar year the contributions are made (or at least prior to the tax filing for the calendar year). Income taxes are paid when distributions (withdrawals) are made, usually during retirement years.
The maximum contribution for 2021 and 2022 is $6,000. An additional $1,000 "catch up" contribution can be made for individuals age 50 or older during the year. There are no income limits for traditional IRA contributions; however, there are limits on receiving tax deductions beginning at $66,000 modified adjusted growth income (MAGI) for singles and $105,000 MAGI for those married filing jointly in 2021. These limits increase to $68,000 for singles and $109,000 for married couples in 2022.
A Roth IRA is funded with after-tax dollars and grows tax-deferred. You can withdraw only your contributions from a Roth IRA with no penalty at any age. At age 59 1/2, you can withdraw both contributions and earnings with no penalty, provided your Roth IRA has been open for at least five tax years. The maximum contribution for 2021 and 2022 is $6,000. An additional $1,000 "catch up" contribution can be made for individuals age 50 or older during the year.
For 2021, you can make a full contribution if your MAGI is less than $125,000 and you're filing as single. Those married filing jointly can make a full contribution if your MAGI is less than $198,000. These limits increase to $129,000 for singles and $204,000 for married couples in 2022.
Designed for self-employed individuals, small-business owners and their employees, a SEP IRA is funded with pre-tax dollars and grows tax-deferred. Withdrawals are taxed at 10%, as are traditional IRA distributions. The contribution limit is the lesser of the two: 25% of salary or $58,000 in 2021. This increases to $61,000 in 2022.
These employer-sponsored retirement plans are funded with pre-tax or after-tax (Roth) contributions, which grow tax-deferred until withdrawal after separation of service from the employer. Many employers offer matching contributions when employees contribute their own money through payroll deduction.
The contribution limit increased is $19,500 for 2021 and increases to $20,500 in 2022. The catch-up contribution for participants age 50 and older is $6,500 in 2021 and 2022. Limits do not include employer-matching contributions. The 10% early withdrawal penalty applies for distributions made prior to age 59 1/2.
Similar to 401(k) plans, 403(b) plans are employer-sponsored plans with the same contribution limits and employer-match feature. 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 benefit, consider these primary factors:
- Your income: Generally, individuals with high income benefit most by making pre-tax contributions. The opposite is also true: If you are in a low tax bracket, you may benefit most by making Roth contributions. Since traditional and Roth IRAs have income limits, some individuals will not qualify to make contributions. Also, you must have earned income to contribute to an IRA. One exception to this is when one spouse has earned income and the other does not. The employed spouse may be able to make contributions to a spousal IRA.
- Availability of employer-sponsored plans: If you have access to a 401(k) plan or 403(b) plan, and the employer is making matching contributions, you should make your own contributions, at least up to the minimum amount to receive the full match. IRAs don't have a matching feature.
- Small-business owners: If you own a business with few or no employees, you may have more options for retirement plans for yourself and your employees.
Here are the primary retirement plans and the individuals who benefit most by them:
- Traditional IRA: Best for individuals who expect to be in a lower tax bracket in retirement than they are when contributions are made, or those who need to reduce current taxable income. Must have earned income (or a spouse with earned income) to make contributions.
- Roth IRA: Best for individuals who expect to be in a higher tax bracket in retirement than they are when making contributions. Must have earned income (or a spouse with earned income) to make contributions.
- SEP IRA: Best for small-business owners and self-employed individuals who want a simple means of maximizing retirement plan contributions, which are potentially higher than other IRA types.
- 401(k) plan or 403(b) plan: Best for individuals eligible to participate, and when an employer offers matching contributions. Also ideal for individuals whose income is too high to contribute to a traditional or Roth IRA. Most 401(k) plans allow for either traditional or Roth contributions.
The Bottom Line
Saving for retirement in a tax-advantaged retirement plan is almost always a good idea. When capital gains and dividends are not taxed, the advantage of compound interest advantage in investing becomes more powerful.