Different Types of Retirement Plans and Their Tax Benefits
Contributing to retirement accounts is one of the smartest investments you can make with your money, as it helps to secure your financial future—and, as an added bonus, many of these contributions offer tax benefits. If you have more than one type of retirement account, and you don’t have the funds to max out all of them, you may be wondering which account you should focus on to get the greatest tax benefit. Keep reading to learn more about the different types of accounts, how taxation on contributions work, and how to determine the best account to put your money in first.
Employer 401(k) Plans
401(k) retirement accounts are most often established through an employer. Contributions to the account are typically taken out of your paycheck before you’re paid, and your employer may even offer a contribution match up to a certain amount. These accounts do have a maximum amount that you can contribute, with the limit for 2020 being $19,500. Catch-up payments are also permitted for those over 50; these individuals can contribute an additional $6,500 per year.
The greatest benefit to 401(k)s is the ability to make pre-tax contributions. Because your employer can deduct those funds before taxes are applied, your taxable income is automatically reduced, and you’re putting tax-free money into an account for your later use. However, this does mean that when you withdraw from your 401(k) after retirement, all distributions will be considered taxable income.
Traditional IRA Accounts
There are two types of IRAs, and both are established through your financial institution, stockbroker, life insurance company, or mutual fund. The maximum annual contribution to an IRA is currently $6,000, though catch-up payments are also permitted for these accounts; for 2020, those over 50 can put in an extra $1,000.
Like 401(k)s, traditional IRAs are considered a pre-tax contribution. However, because deposits to these accounts are typically made from your personal funds (after taxes have already been applied to those funds), these contributions would need to be written off as a deduction when you file your tax return. The write-off would then reduce your tax liability, thereby reducing your tax bill or increasing your refund amount.
Again, because these are pre-tax contributions, distributions from these accounts are taxable. It’s also important to note that you can’t withdraw from these accounts before the age of 59 ½. Withdrawing from a traditional IRA early would not only make those funds subject to your regular income tax, but an additional 10% early withdrawal fee. There are some exceptions to these fees, depending on how the funds are being used (such as a first-time home purchase), but be sure to discuss the matter with one of our accountants to learn if your early withdrawal would be covered.
Roth IRA Accounts
The second type of IRA account (and the last type of retirement account we’ll be discussing) is a Roth IRA. These accounts are subject to most of the same rules as traditional IRAs, including early distribution fees, catch-up payments, and contribution limits. Please note that the contribution limit of $6,000 (or $7,000 for those over 50) is the maximum amount you can contribute to any IRA account. So, if you have both a Roth and a traditional IRA, your total contributions between the two accounts cannot exceed $6,000 (or $7,000 if you qualify for catch-up payments).
Roth IRAs have one major difference from traditional IRAs—when they’re taxed. Deposits to this kind of IRA are considered post-tax contributions. This means that you cannot write off your investments into these accounts; but, when you begin withdrawing from them, those funds are not considered taxable income.
So Where Should You Invest?
Now, to answer the question you really want answered: Which accounts should you deposit to first? Unfortunately, there’s no easy answer, as it’s largely going to depend on factors like your income and your retirement plans and goals. However, as a general rule, it’s a good idea to diversify your retirement investments; this means dividing your retirement deposits between pre-tax and post-tax accounts.
If your employer offers contribution matching for your 401(k) plan, you should absolutely max out that match first. Then, consider maxing out your Roth IRA, so that you have both pre-tax and post-tax retirement contributions.
But what about traditional IRAs, you ask? If you believe that your current income is significantly higher than what it will be after you retire, it may be better for you to invest in a traditional IRA instead of a Roth IRA. When you retire, you’ll likely be in a lower tax bracket, so you’ll pay less in taxes when you withdraw those funds than you would be paying on them now. However, only your accountant can tell you exactly what the best investment option is for you.
If you want help deciding the best way to invest and maximize your tax benefit, contact us for an appointment today.