When it comes to saving for retirement, utilizing a tax-advantaged plan can make a huge difference. The question then arises of what exactly is the best tax-advantaged retirement account.
Basically all retirement plans that are found in a section of the tax code offer tax-free growth as long as the account holder leaves their money alone. Those who opt for Roth funds pay their taxes up front, but any growth that their contributions provide is tax-free when it gets withdrawn, as long as the withdrawal comes after age 59.5.
There are benefits and drawbacks to just about any retirement account that provides tax benefits.
Those who are looking into early retirement could benefit most from a traditional IRA. There is also the Roth conversion ladder that could allow early retirees the opportunity to save on taxes while in early retirement.
Taking Out Funds Early
When it comes to saving for retirement, Roth contributions can be removed without a 10-percent penalty for early withdrawals. The reason for this is the government views these funds as having already been taxed. Traditional accounts like 401k, 403b, and IRAs do not have this benefit. They incur a higher tax bill when even the contributions are withdrawn.
Why? The government does not view this income as having been tax on the front end. Therefore, those who take out any funds from a 401k (unless it's a Roth version), a 403b or a traditional IRA will be subject to regular income tax at whatever the marginal rate happens to be plus a 10 percent penalty for early withdrawal if the withdrawal happens before age 59.5.
There are a few exceptions to the penalty, and some of them are tied to financial hardships. Ideally, these funds are for retirement, and account holders are able to leave them alone for the long term.
Who Gets To Invest With What Account?
The general rules when it comes to the section of the tax code that investors can use to minimize their taxes are as follows:
- IRA accounts are for individuals who are within the maximum income limits
- 401k accounts are usually sponsored by private companies
- 403b accounts are offered by nonprofit entities
- There also options for self-employed folks, but most Americans are familiar with the accounts listed above
What Are Contribution Limits?
Again, as a general rule, those who invest in a 401k or a 403b account can put as much as $18,500 away each year (as of 2018). This does not count any employee contributions, so the account could actually get more in terms of contributions in a year. Anyone who has reached age 50 can put an additional $6,000 away each year for catch-up contributions.
Those who are looking to save in an IRA (both the Roth and traditional versions) and fall within the income limits can save up to $5,500 a year as of 2018. Those who are age 50 or older can put an additional $1,000 away each year.
There is no rule that prohibits a person from putting the max toward each account each year. Therefore, those who are below 50 can put $24,000 toward retirement in a tax-advantaged account each year. Those who are past their fiftieth birthday can add $7,000 to this maximum contribution.
Are These The Best Options?
When it comes to saving for retirement, there might be a better option for those who are employed in the public sector, as well as some nonprofit employers. This would be those who are employed for state or local governments or public schools.
Many school systems offer a 403b account, and saving through them can be a good idea. However, an even better option, especially for those who might want to retire or scale back work before the normal retirement age of 62 or older, would be a 457 plan.
These plans are sold as deferred compensation accounts, and they come with many of the same benefits of accounts such as 401k or 403b accounts.
For 2018, it's possible to save up to $18,500 in a 457 account. Savers can opt for pre- or post-tax deductions from their paychecks. The pre-tax option will save on taxes in the immediate term. The saver will avoid paying the marginal rate on any dollars saved in a 457 account. For example, if a person with a 25-percent tax rate saved $1,000, they would save $250 in taxes. If another saved $1,000, but had a marginal rate that fell within the 12-percent bracket, savings would still exist, but they would only be $120, rather than the $250 noted above.
The Best Benefit Of 457 Accounts
The tax benefits of a 457 are similar to traditional 403b and 401k accounts. However, this is not the biggest benefit. The biggest benefit comes for those who leave employment before age 59.5 when it's time to make withdrawals.
Because most people will opt to save on taxes in the near term, there will be regular income taxes due on any withdrawals. However, those who save in a 457 account do not have to pay the 10-percent penalty that's common for many other retirement savings vehicles that come with tax advantages.
This lack of a 10-percent penalty for those who have retired or moved on to other ventures before age 59.5 make the 457 account a great option for those who actually have access to them. Any funds that remain in the account remain sheltered from taxation until they are withdrawn.
Those who are looking to retire early and who work with a state or local government agency or a school system that offers a 457 deferred compensation plan should really look into this option to supercharge their retirement savings.
An Additional Benefit
Many government agencies and school systems still offer traditional retirement defined-benefit retirement plans. Some of these can be quite lucrative for those who are able to log two or three decades in public service. Saving in a 457 plan could allow these folks to retire earlier than they otherwise might be able to.
Even saving 4 or 5 percent of income for a couple of decades could lead to tens or hundreds of thousands in retirement savings that fall outside of the actual pension. Those who are looking to retire early could tap these savings to fund a few years of early retirement before their pensions and Social Security (provided that their employer participates) start to flow their way around age 62. Those who are able to save a larger percentage of their pay will be in even better shape for retiring early.
Totally Maximizing Savings
Some employers will offer both a 457 plan and a 403b. Employees can save in both of these accounts up to the maximum. That means that the first $37,000 for some employees could get exempted from taxes in the immediate term. Obviously, the idea that public workers are paid ridiculous sums of money for very little work is largely a myth. Therefore, it's pretty likely that only those with spouses who make quite a bit will be likely to save the max in both.
This is a worthy goal, however, as saving $37,000 a year would really supercharge one's retirement savings in a big way.
Given this option, those who are looking to retire early and who cannot save $37,000 would likely be better off saving in the 457 plan because there is no 10-percent penalty associate with "early" withdrawals.
A Final Consideration
It's important to look at the management fees that the funds offered charge. Some 457 plans offer low-cost funds from brokerages like Vanguard or Schwab. Investors will generally be better off using one of these options then an actively managed fund with fees that can run a percent or two (or even more).
Be sure to check out the prospectus for each fund that you're considering and take the management fees into account before making a choice. If the fees are low and the funds are solid, a 457 plan could be a really good decision for retirement savings.
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Additional disclosure: I am not a financial professional. The information provided in this article are for educational/entertainment purposes. Please do due diligence before making investments, as losses can occur.