You Thought You Knew Everything About Retirement Saving Tax Advantages… Until Now
Tax Day is approaching and we all have money on our mind. While potential tax-advantaged savings exist, retirement saving is a key area to decrease your current taxable income. From 401(k)s to retirement savings for the self-employed, here is the ultimate guide to retirement savings tax advantages:
For the Traditional Employee…
A Traditional 401(k)
A 401(k) is a defined contribution plan. It is a long-term investment tool for retirement saving where you invest tax-deferred earnings into a diversified account which may consist of stocks, mutual funds, bonds, and other investments. A 401(k) plan is sponsored by an employer, who will select a company to manage each employee’s account. The account balance grows on a tax-deferred basis, allowing you to benefit from compounded growth without having to draw down the account each year to pay taxes. Once you hit 59½ years old, you can begin to withdraw funds from the 401(k) penalty-free1. In tax year 2016, you can contribute a maximum of $18,000, unless you are 50 years old or over, in which case you can contribute a maximum of $24,000.
Tax Benefits of a 401(k)
People are drawn to 401(k)s for not only the opportunity to compound money over time but also as a tax benefit. Here, you put off the tax burden until the funds are distributed. Money invested in a 401(k) is not subject to federal income tax when it is contributed and the balance grows on a tax-deferred basis. However, you do pay income taxes on the distributions.
A designated Roth 401(k) is another retirement savings option that is new to the scene. A growing number of financially progressive employers pair a traditional 401(K) with a Roth 401(k). Unlike a traditional 401(k), you pay tax on your contributions, but you pay nothing when you withdraw come retirement time. The 2016 aggregate annual contribution limit for a traditional 401(k) and a Roth 401(k) is $18,000 for those under 50 and if you are over 50, you can contribute an additional catch-up amount of $6,000.
If your employer does not offer a Roth 401(k), you may qualify to open a Roth at any number of financial services companies. Like a Roth 401(k), contributions to a Roth are not deductible when made, but the account balance grows tax-free and you are not taxed on distributions made after age 59½. The 2016 contribution limit for a Roth is $5,500 plus an additional $1,000 if you are age 50 or over.
Tax Benefits of a Roth 401(k)
With a Roth 401(k), it’s not about deferring taxes, it’s about investing in a flexible tax-free retirement. Young investors are particularly drawn to Roth 401(k)s because most are confident they will be earning more in the future — thus in a higher tax bracket— and would prefer to pay taxes on the amount now. Paying tax up front is a little painful, but you can end up with more money come retirement age. Plus, the money within your Roth 401(k) grows tax free and you won’t have to pay income tax on it when you take it out.2
Retirement Savings Accounts for the Self-Employed…
As a freelancer, saving for retirement requires more planning because a strategy is not neatly laid out by your employer. But, you have options that result in potential tax savings. Read on to learn more:
A Solo 401(k), or one-participant 401(k) plan, allows you to choose funds just like a regular 401(k) plan, but you can set it up and contribute independently. With this type of retirement fund, high contribution limits allow you to add more than any other retirement plan for the self-employed. If you have recently transitioned to self-employment, this plan is particularly desirable because you can easily rollover previous 401(k)s.
Keep in mind that you are only allowed one 401(k). The contribution limit for elective deferrals is $18,000 (plus an additional $6,000 if you’re 50 or older) up to 100% of compensation. An employer nonelective contribution (also called profit sharing contribution) is allowed at up to 25 percent of net earnings. The total contribution cannot exceed $53,000 (for 2016), or $59,000 if age 50 or older.
Tax Benefit of a Solo 401(k)
A Solo 401(k) has the same tax benefits as a traditional 401(k). Contributions are not taxed in the year contributed and the account balance grows on a tax-deferred basis. But, like a 401(k), you are taxed when you withdraw funds from the account. You can design a Solo 401(k) plan to allow a designated Roth option, allowing you to save after-tax dollars. As a result, you won’t be taxed when you withdraw your funds later down the line when your tax bracket will likely be higher.
SEP (Simplified Employee Pension) IRA
A Simplified Employee Pension Plan (SEP) is a low-cost option for small business owners and the self employed. With a Simplified Employee Pension Plan, you can make contributions to a traditional IRA set up for each plan participant (a SEP-IRA). Like other types of plans, SEP IRAs come with a few restrictions. For example, you can contribute as much as 25 percent of your net earnings, but not more than $53,000 in 2015 or 2016. You have until the due date of your tax return, including extensions, to set up and contribute to a SEP IRA. To set up a SEP, you must execute a written agreement to provide benefits to all eligible employees.
Tax Benefit of a SEP-IRA
SEP-IRAs have tax-deferred growth potential until withdrawal and there are not mandatory contributions or annual tax filings. The most you can deduct for SEP-IRAs is the lesser of your contributions (up to $53,000 for 2015 and 2016) or 25 percent of your total compensation. Be aware that contributions must be in accordance with the allocation formula adopted in the SEP plan document (likely Form 5305-SEP).
For more information on self-employed retirement options read this helpful guide from the IRS.
Taxes are one of the largest expenses you incur each year, so it’s worth your time to educate yourself to minimize the overall amount you are taxed on. Review our library of blog posts on Block Advisors Insights for more resources on tax-advantaged savings.
1 In certain circumstances, you can take out 401(k) funds prior to age 59½, but you will incur a 10% early withdrawal penalty unless an exception applies.
2 Roth 401(k)s are subject to required minimum distribution (RMD) rules. So after you turn 70 ½, you will be required to start withdrawing money from the account. Roth IRAs are not subject to RMD rules.