An employer sponsored 401K plan is a great way to save for retirement, especially if the employer provides a “match” on a portion of your contribution. The 401K vehicle can be either a traditional plan where your contribution reduces your income before taxes are assessed, or a Roth 401K where you don’t get a tax deduction when contributing, but you won’t pay any tax on distributions in retirement.
Not everyone’s employer sponsors a 401K plan, or perhaps you are self-employed. What are the best ways in these situations? Fortunately, there are options available.
We have three learning objectives for this post:
To understand the types of tax-qualified retirement accounts available if your employer does not offer a retirement plan
To learn the differences between taxable savings accounts, traditional tax-qualified accounts and “Roth” versions of qualified plans or accounts
Lastly, how to decide which type of retirement savings vehicle is the best for your situation
First, let’s assume you are employed, but the company does not offer a retirement plan. In this case there is a combination of options. The first is putting aside available savings in a “taxable” (AKA – non-qualified account). This could range from a savings account at a bank to an investment account at a mutual fund company or brokerage firm. You don’t receive any tax deductions for depositing money in these accounts and you pay tax along the way as your investment activity creates income, such as dividends and interest or capital gains if you sell an investment for a profit. These firms will issue a 1099 tax form early each year which contains information that must be represented on your tax return for the previous year. There is no limit on how much you may deposit into non-qualified accounts each year.
All individuals who have earned income from employment or self-employment may contribute to an IRA each year. The type of IRA you choose to contribute to will depend on the tax benefits you desire and in some cases your level of household income, which can limit contributions to Roth IRAs and reduce the tax deductibility to traditional IRAs if you participate in an employer sponsored plan.
Traditional IRAs can always be contributed to up the annual maximum each year, even if you participate in an employer plan. The maximum is currently $6,000 for those under age 50 and $7,000 for those age 50 or higher. Participation in an employer plan may reduce or eliminate the tax deduction normally associated with the contribution, depending on your level of household income.
If you are not participating in an employer plan and value the tax savings the deduction provides, then the traditional IRA is still a valuable savings vehicle. Keep in mind that when you withdraw funds from the traditional IRA in retirement, it is considered ordinary income for income tax purposes and you can expect to receive a 1099.
The other IRA option is the Roth IRA. While contributions are subject to household income limitations, Roth’s do not provide any tax deduction in the year of contribution but have the benefit of no taxation when distributions are taken during retirement. So between these types of IRAs, you get to choose when you want to receive the tax benefit, now or later. Annual contribution limits for Roth IRAs are the same as for Traditional IRAs and these limits tend to rise over time as adjusted by Congress to keep up with inflation.
Both types of IRAs offer one main advantage. Tax-deferred growth. This means that money in and IRA can earn all the interest, dividends and capital gains you can achieve and there won’t be any 1099s issued until you withdraw funds in retirement. Over long periods of time, the avoidance of taxation helps your money compound at a higher rate and can make large differences in accumulated values compared to non-qualified accounts
Let’s assume you are self-employed. The first three retirement savings options we’ve reviewed are available to you. Non-qualified savings and investment accounts are always available to everyone. Traditional IRAs offer an immediate tax benefit and Roth IRA provides the tax benefit later. Remember, Roth contributions may be limited by your household income.
As a self-employed person you also have another choice, such as starting your own retirement plan! There are a few plans easily available which allow for larger contributions than allowed by IRAs. Solo-401Ks and Simplified Employee Pension Plans (SEP-IRAs for short) are great for those who own their own business, especially those with no employees.
Contributions to solo-401Ks and SEP-IRAs are limited by caps set by the federal government and percentages of self-employed profits in the case of SEP-IRAs. But even with these limitations, you may be able to more than double the amount you can contribute into tax-deferred investments to save for your retirement.
Our last learning objective is to be able to decide which type of IRA (Traditional, SEP-IRA or Roth) or Solo 401K (either Traditional or Roth) to use for your situation. Let’s keep in mind that a combination of types can be used as long as the income limitations for Roth contributions is not violated.
For self-employed individuals who plan on saving more than the IRA annual contribution limits the Solo 401K or SEP-IRA are definitely worth considering. The SEP-IRA and traditional 401K offer immediate tax savings, while the Roth 401K offers tax savings later. Of course with the limits on contributions you may find you want to save more than these vehicles allow.
Traditional IRAs can be used by anyone with earned income. The contribution may or may not be tax deductible depending on whether you also established a SEP-IRA or Solo 401K and is based on household income, with high wage earners being phased out of the tax deduction.
For those participating in a plan like a SEP-IRA or Solo 401K whose income isn’t too high, the Roth IRA makes a great place to put aside that extra retirement savings. In summary, no matter what your situation there are multiple options for establishing your retirement saving and investment plan.
For help in planning your retirement savings, call us today at 941-778-1900 or visit www.integracapitaladvisors.com to schedule a time to talk.