Which Type of Retirement Account Offers the Greatest Tax Benefit?
Contributing to retirement accounts is essential to your financial stability later in life. But if that’s not enough of a motivator for you, they also offer significant tax benefits when you contribute to them. If you have multiple retirement accounts, you might be wondering which one offers the biggest tax benefit for your contributions. Of course, the answer isn’t really that simple, and it depends on your individual financial situation. If you want to know how to best plan for your retirement and maximize your tax benefits for your contributions, it’s best to meet with one of our financial planners. However, here’s a quick, general overview of the different retirement accounts and their benefits.
Traditional IRAs are typically set up through your financial institution. However, they can also be established via your life insurance company, stockbroker, or mutual fund. Contributions to a traditional IRA are tax deductible. So, any amount that you contribute to this account is deducted from your taxable income when you file your return. Obviously, this is an immediate tax benefit to you and will reduce your tax liability for the current tax year.
However, distributions taken from a traditional IRA are taxable at your standard tax rate. So, when you begin taking distributions after you retire, those withdrawals will be considered taxable income. Additionally, if you withdraw from your traditional IRA early (before the age of 59 ½), those withdrawals can be subject to a 10% tax. There are some exceptions to this, but be sure to discuss any early withdrawals from your account with your financial advisor or CPA to find out if it will be exempt from the early distribution tax.
IRAs also have a maximum contribution of $6,000 per year, so it’s a good idea to have additional retirement accounts that you can contribute to if you max out your contributions to this account.
Roth IRAs are subject to many of the same rules as traditional IRAs, including the early distribution tax and the contribution limits. However, it’s extremely important to note that the contribution limit is a total limit for contributions to all IRA accounts. So, if you have both a traditional and a Roth IRA, you can only make a total of $6,000 in contributions between the two accounts.
The major difference between Roth and traditional IRAs is when the funds are taxed. Contributions to Roth IRAs are not tax deductible, so you will have to pay tax on any funds you contribute to this account. However, when you receive your distributions (excluding early withdrawal fees), the funds are not considered taxable income.
A 401(k) is established through your employer, and the contributions to your account are typically withdrawn directly from your paycheck. Additionally, many employers will provide matching contribution benefits to their employees up to a certain amount. Like a traditional IRA, these contributions are pre-tax; however, since the deposits are usually taken off your paycheck before taxes are applied, you wouldn’t deduct them on your tax return.
And, like a traditional IRA, any distributions you take from a 401(k) are taxable income, including any earnings the account has garnered over the years. Like other retirement accounts, 401(k)s do have contribution limits; the limit for 2020 is $19,500.
Which Is Best?
Now that you have a basic understanding of the benefits of these different accounts, how do you know which is best for you to contribute to? The correct answer will vary from one person to another and depend on your retirement plans and income. For example, there are actually income thresholds that may prohibit you from contributing to a Roth IRA at all; we can tell you more about these if they apply to you.
However, here’s a general outline of an effective way to invest in your retirement accounts:
1. If your employer offers contribution matching on your 401(k) plan, max this out first.
2. After this, it’s usually best to diversify your tax portfolio. So, since 401(k)s are a pre-tax contribution, you should consider contributing to your Roth IRA. This will mean that a portion of your retirement funds are taxable, while some isn’t.
3. After maxing out your Roth IRA contribution, max out your 401(k) as well, if you can.
You may be wondering then, “Do I even need a traditional IRA?” Obviously, everyone’s financial situation is different, and some will find contributing to a traditional IRA more beneficial than a Roth IRA. This is often the case for those in a high tax bracket; by contributing to tax-deductible accounts now, they’ll pay less in taxes when they’re on a fixed, lower income after retirement.
If you’re unsure which retirement accounts are best for you to contribute to, contact us. We’ll go over your options and help you plan for retirement while making the most of available tax deductions.
Camputaro and Associates
Certified Public Accounting Firm
136 N. Orchard Street, Suite 8
Ormond Beach, FL 32174