Which Retirement Plan Offers the Best Tax Benefit?

Which of the Following Retirement Plans Offer the Best Tax Benefits?

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Choosing the 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

There are many different types of retirement plans to choose from but the primary retirement savings vehicles are the Traditional IRA, Roth IRA, SEP IRA, 401(k) Plan.

Here are the primary features and benefits of each type of retirement plan:

  • Traditional IRA: Funded with pre-tax dollars and earnings grow tax-deferred. This means that contributions reduce taxable income during the calendar year 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. Maximum contribution is $6,000 in 2019. An additional $1,000 "catch up" contribution can be made for individuals age 50 or over during the year. There are no income limits for traditional IRA contributions; however, there are limits on those contributions for receiving tax-deductions beginning at $64,000 modified adjusted growth income (MAGI) for singles and $103,000 MAGI for married filing jointly.
  • Roth IRA: Funded with after-tax dollars and grows tax-deferred. Withdrawals are tax-free and penalty-free if made after age 59.5 and at least five years after the account was opened. Maximum contribution is $6,000 in 2019. An additional $1,000 "catch up" contribution can be made for individuals age 50 or over during the year. For 2019, you can make a full contribution if your MAGI is less than $122,000. Married filing jointly can make a full contribution if MAGI is less than $193,000.
  • SEP IRA: 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 ordinary income rates, as are traditional IRA distributions. Contribution limits are the lesser of 25 percent of income or $56,000 in 2019.
  • 401(k) Plan: 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. Contribution limit for 2019 is $19,000. Catch up contribution of $6,000 for participants age 50 and higher. Limits do not include employer matching contributions. The 10 percent early withdrawal penalty applies for distributions made prior to age 59.5. 
  • 403(b) Plan: Similar to 401(k) plans, 403(b) plans are employer-sponsored plans with the same contribution limits and matching feature. Also called tax-sheltered annuities (TSAs), 403(b) plans are typically available through public schools and employers of 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.

Which of the Following Retirement Plans Offer the Best Tax Benefits?

Here are the primary retirement plans and the individuals who benefit most by them:

  • Traditional IRA: Best for individuals that 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 that expect to be in a higher tax bracket in retirement than they are when 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 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. 

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 compounding interest advantage of investing becomes more powerful. 

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.