November 10, 2017
There has been a significant amount of news reporting recently about tax reform proposals that may put a cap on certain retirement plan contributions (401(k) plans in particular). This discussion has highlighted the complexity of the available retirement plan options, and the importance of understanding what options you may personally have.
Due to the sheer number of retirement plan options, this article will highlight the most common options, their eligibility criteria, and any notable special features. In many cases, you may be eligible to contribute to 3 or 4 different types of plans, perhaps all at once. Understanding your options is your first step in maximizing your contributions. The second step – outside the scope of this article – is to understand your investment options and make sure you are harmonizing them with the particular retirement plans you are using (see earlier article on this topic)
401(k) – Roth & Traditional
Ubiquitous and widely used by employers, 401(k) plans have a fairly high limit of $18,000 for employee contributions, plus a $6,000 catch-up contribution for workers age 50 or older (2017 limits). You can only participate in a 401(k) plan if your employer offers it, or if you set one up at a business that you own. In general, you should contribute to your 401(k) plan at a minimum an amount to maximize any employer’s matching contribution. Above the matching level, you may have better options with other retirement plans, so review the possibilities before making a determination.
401(k) plans come in two general flavors – a traditional plan, and a Roth plan. Many employers offer both plans, so check to see what is available to you. A traditional 401(k) plan allows your contributions to be pre-tax. In other words, you don’t pay income tax on any compensation that is deferred into your retirement account. However, any future distributions out of the account in retirement will be fully taxable. A Roth plan is essentially the opposite from a tax standpoint. Roth contributions are post-tax, meaning that you pay income tax on every dollar that you contribute into a Roth 401(k) plan. On the plus side, all qualifying distributions in retirement are fully tax-free. Determining which option to go for can be complex – make sure to consult with your tax advisor. In general, a traditional plan is best for taxpayers in peak earning years, and who expect their income tax rates to be lower in retirement. A Roth plan is generally best for those in the early stages of their career, those who expect their estate to be subject to the estate tax, or those who expect tax rates to be higher in retirement.
Health Savings Account
You might be surprised to see the Health Savings Account (“HSA”) on a list of retirement plan options. While technically an HSA is set up to fund medical expenses, it can operate as the most tax-advantaged “retirement” plan option available to you. You need to have qualifying high-deductible insurance in order to make contributions to an HSA, so review qualification rules carefully before making any contributions. Preferably, you contribute through your employer’s plan, which generally results in all contributions avoiding income tax and FICA tax (an additional 7.65% benefit). Total contribution limits for 2017 are $3,400 for those with self-only medical coverage, and $6,750 for those with family coverage.
In general, in my opinion you should prioritize HSA contributions directly behind any 401(k) matching opportunities. Contributions to an HSA are pre-tax (avoiding FICA taxes in addition if through an employer plan) which results in significant up-front benefits. Most importantly, HSA funds can grow in the account free of tax, and are completely non-taxable if distributed for qualifying medical expenses. Most good HSA custodians allow plan assets to be invested, so some taxpayers will make contributions, pay medical expenses out of pocket, and allow the invested HSA balance to grow for use with medical expenses in the retirement years. In addition, after age 65 or Medicare eligibility, the funds can also be withdrawn for non-medical purposes – the downside of this option is that income tax must be paid on non-medical distributions similar to a traditional 401(k).
Simplified Employee Pension (SEP) IRAs
If you are self-employed or own a business, you may be able to take advantage of an SEP IRA. Contributions to an SEP plan are generally limited to 25% of compensation, or $54,000 (2017). Contributions generally are due by the due date (including extensions) of the applicable income tax year, and they come solely from the employer – no employee contributions are permitted. This type of plan is very favorable and flexible – you can determine your precise tax situation, and determine exactly how much you would like to contribute to the SEP to optimize your tax situation. Contributions reduce taxable income, and any future distributions in retirement are fully taxable.
SEP IRAs are very simple to set up, administered similar to an individual IRA account, are very flexible, and have very high contribution limits. On the downside, you generally need to make contributions to all employees at the same rate. For example, if you have three long-term full-time employees, and you want to contribute the maximum for your personal earnings, you will also need to contribute based on the same percentage for the other employees. Exceptions do exist for employees under age 21, those who have worked less than 3 out of the last 5 years at your business, or those who received less than $600 of compensation.
Traditional IRAs
Similar to traditional 401(k) plans, a traditional IRA allows you to make pre-tax contributions, and all distributions in retirement are fully taxable. The 2017 contribution limit is $5,500 for those under age 50, and $6,500 for taxpayers that are age 50 or older, but cannot be greater than compensation earned during the year. If you are covered by a retirement plan at work, your ability to make deductible IRA contributions is phased out completely with modified adjusted gross income (MAGI) over $71,000 if you are single, or $118,000 for a married couple filing jointly. Non-deductible contributions are possible for taxpayers not eligible to deduct their contributions, but this type of contribution doesn’t make sense for most people.
Roth IRAs
Similar to the Roth 401(k) plans mentioned earlier, Roth IRAs allow for post-tax contributions, with all qualifying distributions in retirement to be completely free of income tax. The contribution limits are identical as traditional IRAs - the 2017 contribution limit is $5,500 for those under age 50, and $6,500 for taxpayers that are age 50 or older, but cannot be greater than compensation earned during the year.
The eligibility catch for Roth IRA contributions is based on modified adjusted gross income and your tax filing status. In general, single individuals with MAGI over $133,000 are not eligible, as are married taxpayers filing jointly with MAGI over $196,000. One potential benefit to a Roth IRA is a special rule allowing you to withdraw contributions to your Roth IRA without any tax or penalty implications. Any investment earnings are not eligible for this special perk – only contributions. For example, if you contributed $5,000 to a Roth IRA, it grew to $8,000, and then you needed $4,000 for an emergency – you could withdraw this amount without penalty since it is less than your contributions.
SIMPLE IRA
Think about a SIMPLE IRA as a cousin of the 401(k) that is less complex and has much simpler administration rules, but also has lower contribution limits. A SIMPLE plan must be formed by October 1st of the year in which it will be used, with employee funding coming from paychecks as collected, and employer funding due with the extended due date of the business tax return. The normal contribution limit for 2017 is $12,500, and the higher contribution limit for employees age 50 or above is $15,500. Employers are generally required to offer either matching contributions up to 3% of compensation, or must make a non-elective contribution of 2% of the employee’s contribution.
This particular type of retirement plan usually works best in small businesses that don’t want to use the SEP IRA (usually due to the requirement that employer contributions be the same percentage for all employees), and who also don’t want to set up a 401(k) plan (usually due to headache of administration, non-discrimination rules, etc.).
Defined Benefit Plan
In the current economic environment, defined benefit plans are increasingly rare birds. These plans are rare because they require that the employer make certain promises for retirement benefits – very unlike 401(k) plans that define employee contributions, but not actual retirement benefit levels. In addition, these plans can be incredibly complex, with involvement from actuaries, attorneys, and many other professionals to make sure they are operated properly.
On the positive side, defined benefit plans do allow a limit of benefits equal to the lesser of 100% of the employee’s average compensation for their highest earnings 3 consecutive calendar years, or $215,000 (2017 limit). This is an incredibly high limit, which is the main reason that these plans are still used in certain circumstances. In general, these types of plans should be explored with businesses with owners age 50 or older in their peak earning years, that only have one employee/owner, or with a handful of owner/employees or very highly compensated long-term employees. The cost and complexity of these plans can be substantial, but there can be enormous upside potential in the right situations.
Other Retirement Plans
The retirement plans discussed are not intended to be exhaustive, and other common plans include 403(b) plans (typically used by governments and non-profits, and similar in many ways to 401(k) plans), profit sharing plans, nonqualified deferred compensation 409A plans, and nonqualified 457 plans. If you are eligible to contribute to other types of retirement plans, make sure you understand precisely how they operate, and the tax attributes of the plan.
This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation. Please consult your tax advisor for any specifics on these ideas – there are many nuances and issues that have not been fully elaborated in this article.
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