Tax Benefits of Retirement Accounts: Comparing 401(k)s, 403(b)s, and IRAs

Choose the plan that is best for you

You may have access to different retirement account types over your career. This could be a 401(k) if you work for a company that offers retirement benefits, or a Simplified Employee Pension (SEP) IRA if you're self-employed and want to save for the future.

The retirement option you choose to invest in should be the one that fits your financial situation best. This might mean you maintain several different types of retirement accounts over your lifetime and contribute to different or multiple accounts each year. Here's a guide to the various types of retirement accounts you might use and how each one fits into your taxes.

401(k): Employee matching and catch-up

A 401(k) is an employer-sponsored retirement plan for people that work at for-profit companies. The employer must set up the plan, but employees can contribute to it. You can typically invest in mutual funds with these plans. Here are the highlights:

• Annual employee contribution limit (2022): $20,500
• Additional catch-up contributions for those age 50 and older (2022): $6,500
• Income limits for contributions: None, but employee contributions can not exceed wages
• Matching contributions: Depends on your employer's plan

Suppose your employer offers a 401(k) with an employer matching program, meaning your company matches your contributions up to a certain dollar amount or percentage. In this case, you're often best off contributing to this account up until that limit before considering other account types.

403(b): Retirement for teachers and nonprofit employees

A 403(b) is an employer-sponsored retirement plan for employees in public schools and certain tax-exempt organizations, such as religious institutions and hospitals. It may also be referred to as a tax-sheltered annuity plan (TSA), and generally can invest assets in three different type of investments. These include:

• An annuity contract (where you make payments over time in exchange for receiving payment benefits later on)
• A custodial account that invests in mutual funds
• A retirement income account set up for employees of a religious institution

Here are the highlights:

• Annual contribution limit (2022): $20,500
• Additional catch-up contributions for those age 50 and older (2022): $6,500
• Contribution income limits: Includible compensation for your most recent year of service, meaning the amount of wages or payments that is reported on your W-2
• Matching contributions might be available depending on your employer's plan

If your employer offers a 403(b) and matches your contributions, you're typically better off contributing to it up to the matching limit before considering other account types.

IRAs: Self-guided savings

An IRA is an individual retirement account that you set up on your own, without an employer. You get to choose the brokerage firm you open the account with. You must have earned income, such as wages or self-employment income, to contribute to this account type during a tax year.

Here are the highlights:

• Annual contribution limit (2022): $6,000
• Additional catch-up contributions for those age 50 and older (2022): $1,000
• Income limits: Deductibility of contributions varies based on the type of IRA, filing status, and your (or your spouse’s) access to workplace retirement plans
• Matching contributions: None

This account type offers the most flexibility for choosing investments. It's also a good option if you want to contribute additional money toward your retirement goals. Since it doesn't offer matching contributions, take advantage of accounts that do before contributing to an IRA.

SEP IRAs: Retirement for self-employed taxpayers

A simplified employee pension (SEP) plan is an option for self-employed people to fund their retirement. You can only make employer contributions to these accounts, but they have much higher overall contribution limits.

Here are the highlights:

• Annual contribution limit (2022): 25% of net earnings or $61,000, whichever is less
• Additional catch-up contributions for those age 50 and older (2022): None
• Income limits: Maximum compensation that can be considered is $305,000
• Matching contributions: None. All contributions are made by the employer

This option may help self-employed people with high incomes contribute more money to their retirement account. Small business owners may also use this type of retirement plan, but they must contribute the same percentage of each participant's compensation to every person in the plan. This can get expensive fast.

The major subtypes of retirement accounts: Roth vs. traditional

Many retirement account types offer two different options.

Roth retirement accounts

The Roth option allows you to contribute money without reducing your taxable income. These are referred to as after-tax contributions. In exchange for using after tax money in these accounts, you generally get to withdraw the money after age 59 1/2 without paying any taxes at the time of withdrawal. Earnings in the account grow tax-free. This means, as long as you follow the rules, you won't ever have to pay tax on the earnings from this account type.

Traditional retirement accounts

Traditional retirement accounts generally give you a tax break when you pay into them. This means you don't pay federal income tax on the contributions in many cases. These are frequently called pre-tax contributions.

Earnings in the account grow tax-deferred. This means you don't have to pay taxes on the earnings as you make them. Instead, you typically pay ordinary income taxes on all of the money that you withdraw from the account.

How your income could affect your retirement account choice

Your income could affect which retirement account types you can contribute to in two main ways.

Income-based contribution limits

Some retirement account types, such as traditional and Roth IRAs, have rules that can limit your contributions or the tax deductibility of your contributions. These income limits are based on:

• Your adjusted gross income
• Your tax filing status
• Whether you or your spouse have access to a workplace retirement account

You must also have earned income, such as wages from a W-2 job or self-employment income, to contribute to most retirement accounts including IRAs.

Future tax planning considerations

You can use the tax benefits of retirement accounts, such as Roth and traditional retirement accounts, to try to lower your overall tax burden.

If you expect your future tax rate to be lower when you are taking money out of your accounts, you might opt for a traditional retirement account. This could lower your overall taxes if you avoid paying taxes on your income at the higher tax rate today and withdraw the money and pay taxes at your lower tax rate in the future.

The opposite can also be true. If you expect your future tax rate to be higher when you are taking money out of your accounts, you might opt for a Roth retirement account. You can pay taxes today on your contributions. Then, you can withdraw the money tax-free in retirement as long as you meet the requirements. An additional benefit of Roth accounts is that you not only avoid taxes when withdrawing what you contributed but also avoid tax on the earnings. This can be especially beneficial for younger savers since their money will have a long time to grow and be tax free when it is taken out in retirement.

If you're unsure about the future of tax rates, you could contribute to both account subtypes. This provides flexibility when withdrawing money in retirement.

When is the best time to start a retirement account?

The best time to start a retirement account is as early as possible. Compounding investment returns, which is the idea of earnings on your investments making even more earnings, can help the money you contribute earliest in life to grow the most over time.

Starting in 2020, retirement accounts don't have any age-based contribution restrictions. But a person has to have earned income to make contributions, which may be difficult for people under the working age in their state. Although, self-employed people often hire their children at an early age so that they can earn money and begin contributing to their retirement accounts.

Do retirement account contributions have to be reported on your taxes?

Companies such as your employer or brokerage firm usually report your retirement account contributions. But contributions to traditional IRA and self-employed retirement plans such as SEP IRAs and Solo 401(k)s need to be reported on your tax return for a couple of reasons. If your contributions are deductible, you want to take that deduction on your tax return. In some cases, contributions may be nondeductible. When this happens, you need to report these contributions on Form 8606 and keep track of the contributions so that you are not taxed on the same money when you take it out of the accounts.

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