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Looking to get the biggest bang for your buck in retirement savings? Then look first for a plan “qualified” under federal law to offer tax benefits.
Such plans include:
- 401(k) plans — The most common type of workplace retirement savings program.
- 403(b), 457(b), and 401(a) plans— Programs similar to 401(k)s but designed for employees in specific labor sectors, like government and charities.
- Individual retirement accounts (IRAs) — Self-directed retirement savings vehicles.
These plans take pretax contributions and put them, at the selection of the participant, into any of a number of investment options, depending on what is offered under the plan. These can include stocks, bonds, mutual or exchange-traded funds, target-date funds, real estate, and, thanks to recent legislative changes, annuities.
Tax advantages
The key benefit of qualified retirement plans is that the potential earnings in their investments grow on a tax-advantaged basis.
“That growth is tax-deferred — meaning that the growth hasn’t been taxed … yet,” noted Victoria Thomas, a financial professional and vice president with Goldbook Financial in Scottsdale, Arizona. “So, you’ll have the opportunity to pull that income out at a point that may be most beneficial to you tax-wise. Perhaps when you’ve retired, stopped working, and are in a lower tax bracket.”
Additionally, these qualified plans are funded with contributions from your income before taxes are calculated. That can help reduce the amount of income you owe taxes on each year.
Qualified workplace retirement savings plans also often feature an employer match, where the employer contributes a commensurate amount to a certain percentage of the employee’s contribution. Also, under federal law, qualified workplace retirement plans have some protection against bankruptcy claims from creditors.
Limits and restrictions
But qualified retirement plans also come with limits and restrictions.
For example:
- Traditional 401(k) plans only allow contributions up to $23,000 in 2024. If you are 50 or older, you can put in an additional $7,500 each year — called a “catch-up contribution.” (Learn more: What is a 401(k) and how does it work?)
- Traditional IRAs only allow contributions up to $7,000 in 2024 ($8,000 if age 50 or older). And that contribution limit can be reduced depending on your income. (Learn more: DIY planning for retirement with IRAs)
Another drawback for some is that investment choices are limited to whatever the employer or IRA administrator offers in a particular plan. If choices are few, then opportunities for diversification and alternative investments may be constrained. Depending on the options, there may be added fees as well.
Additionally, withdrawals from qualified retirement plans before a certain age, usually 59½, are restricted and could result in an early withdrawal tax unless an exception applies.
However, many plans offer ways to borrow against retirement funds. (Related: The risks of borrowing from your 401(k))
Uncle Sam’s cut
So, when are funds in a qualified retirement plan taxed?
At the time those retirement investment savings are distributed back to the employee, which is usually after they decide to retire or at the age when distributions from qualified retirement plans are required. (Related: Turning 73? Required minimum distributions explained)
Each payment is taxed as ordinary income.
So, the exact amount of tax on a distribution from a qualified retirement plan will depend on your federal tax bracket.
Here's a hypothetical example:
- You get a $20,000 annual distribution from a qualified plan.
- You are in the 22 percent tax bracket.
- You would pay 22 percent of $20,000, or $4,400.
That math may be attractive if you’ve spent most of your working years in a higher tax bracket.
Conclusion
The tax benefits and growth potential of qualified retirement plans can be substantial, especially for those who participate in them early. But they do have limitations and restrictions that may constrain some retirement savings and investment ambitions. That’s why some people look at other options, like Roth IRAs or Roth 401(k)s, although these types of accounts also have some limitations and restrictions.
A financial professional can help you sort out how a qualified retirement plan can fit into an overall financial strategy for retirement and other goals. You can find a MassMutual professional with this tool or you can let us know you’d like to talk with one and we’ll have one of our financial professionals contact you.
Discover more from MassMutual …
3 steps to get your retirement planning started
Is maxing out your 401(k) enough for retirement?
How to set up your first retirement plan
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