This article discusses some of the options my clients look at when choosing the most appropriate personal or business retirement plan. Tax rules around retirement plans are endlessly complex, and there are numerous options available, so this is just a look at some of the most common plans. I am also not including all the exhaustive contribution and distribution details and restrictions, so be sure to delve more deeply before you make a decision.
Deductible vs Non-Deductible Contributions
Deductible plans result in a deferral of tax. Your contributions are deducted from income when you make them. The funds are invested, and income grows tax-free until you start to take distributions later in life, when your tax bracket will probably be lower. If you withdraw funds before age 59 ½ the distribution is added to your taxable income, and with some exceptions, there are additional penalties.
Contributions to non-deductible (or After-Tax) plans, typically ROTH plans, are not deductible when you make them, but the funds are invested and the income also grows tax-free. Distributions later in life are not taxed at all. If you withdraw funds before age 59 ½ your original contributions are not taxed, but only the income earned in the plan is subject to tax and penalties. If you think you may need to withdraw funds early, your tax bill will be lower than with a deductible plan.
There has been a lot of discussion over which plans are better. There is no conclusive answer that I’m aware of, so it’s a matter of personal preference. Speaking strictly personally, I like the idea of reducing my tax now, because who knows what the future holds.
Individual Plans – Traditional and ROTH IRAs
These plans are available to anyone who has earned income from wages or self-employment, but there are income restrictions if you are covered by a retirement plan at work.
Traditional IRA – Your contributions, with some income restrictions, are deductible when you make them.
ROTH IRA – This is an after-tax plan. Your contributions are not deductible when you make them.
Contributions to both plans are limited to $6,500 for 2023, or $7,500 if you are 50 or older. You can contribute to a traditional IRA and a ROTH in the same year, but the total can’t exceed the $6,500 and $7,500 limits.
Backdoor ROTH – If you or your spouse are covered by a retirement plan at work, and your income is above a certain level, you can’t deduct your traditional IRA contribution. Similarly, if your income is over $153,000 ($228,000 if married), you can’t contribute to a ROTH IRA. BUT you can still contribute to your traditional IRA, even if you can’t deduct it. At a later date, there is nothing to stop you from converting the non-deductible IRA contribution to a ROTH IRA… Sounds sneaky, but it’s allowed.
Business Retirement Plans
The most common plans I see with my clients are SEP IRAs and 401(k) plans. These plans allow much larger contributions for business owners than the traditional or ROTH plans discussed above, and are of particular interest to self-employed individuals, as well as partners in partnerships and owners of corporations. Qualified employees must be covered by these plans, so the cost of contributions to the employees’ accounts can be substantial.
The plans are established by the employer or partnership, and contributions are made to accounts in the name of employees, owners or partners. Sole proprietors open the plans in their own name.
The 2023 maximum contribution for these plans is $66,000, or $73,500 if you are 50 or older. This is much higher than the traditional or ROTH limits.
SEP IRA – If you are self-employed or a partner in a partnership or LLC, you can contribute up to roughly 20% of your income after deducting expenses. Owners and employees of corporations are limited to 25% of their W-2 salary. While there are reasons for an S Corporation owner to keep their salary low, maximizing retirement contributions is a reason to pay a larger salary. A point to consider, though, is that paying a higher salary and increasing your retirement contribution both reduce your business income, and therefore reduce your 20% Qualified Business Income deduction, as well as your SALT workaround deduction, which is 9.3% in California.
401(K) Plan – You may work for an employer that offers a 401(K). You are allowed to contribute up to a specified dollar limit or percentage of your salary, and the employer might “match” your contribution, up to a certain limit. For 2023 you can have up to $22,500 (or $30,000) deducted from your pay check. These are good plans, and I encourage you to participate – at the very least up to the amount your employer matches. If you are the employer, you clearly value and care for your employees if you are willing to provide this valuable benefit.
Solo 401(k) Plan – For businesses with no employees, a solo 401(k) can be very beneficial, because there are 2 types of contributions. As noted above, there is the individual “employee” contribution, as well as the “employer” contribution. While the employer contribution is limited to 25% of the individual’s W-2 salary, the owner can make an additional contribution of up to $22,500 (or $30,000). This is nice, because you can contribute more than you could to a SEP IRA. Also, the individual contribution does not reduce your Qualified Business Income deduction or your SALT workaround deduction.
SEP IRAs and 401(k) contributions can allow non-deductible ROTH contributions, if you prefer.
Mega Backdoor ROTH 401(k) – If you are in a high income category, similar to a regular Backdoor ROTH, you may contribute additional non-deductible funds to your 401(k), and roll it over into a ROTH IRA. This is in addition to your maximum $22,500 (or $30,000) pretax contribution. Total employer and employee contributions are limited to $66,000 ($73,500 if over age 50).
Bruce Critchley Tax 