How to Set Up A Tax Free Retirement Account
While opening a tax-free retirement account is a relatively easy matter, let's start with the question of what you are trying to achieve. You would think that is a self-evident answer, retirement! Duh!
Many small business owners, however, are at least as concerned with lowering their taxes. The key is to have an overall financial plan to guide your choice of not only what type of retirement account, but also the underlying investments in those accounts. Without a plan, you are unlikely to achieve what you want for your taxes, either now or in retirement.
On your search for tax-free income, let's explore some things.
What Is a Tax-Free Retirement Account?
There are several options when choosing a tax free retirement account, and we will detail the options later. Essentially we group all accounts with a special tax treatment as a "qualified" account. An example would be an IRA. This is to distinguish it from a non-qualified account, like your checking or savings accounts. Non-qualified accounts have not special tax provisions.
Benefits of Setting Up a Tax-Free Retirement Account
Obviously you are going to choose a qualified or "tax-free" account for the tax benefits. The specific impact on your taxes depends on your individual financial situation, which is why I recommend you start with a plan.
It is important to understand that advice and planning that your doing now in choosing an account will likely change in the future. Tax laws change, and so do the rules for qualified accounts. Just recently the IRS changed the rule for inherited beneficiary IRAs which had a huge impact on how long a beneficiary had to make distributions. So regardless of what account structure you choose now, make sure that you are working with a financial advisor to tax advantage of future changes.
I should point out that one of the disadvantages of these retirement accounts is that you lose any advantage from a lower capital gains tax rate. All of the income distributed from these accounts are taxed as ordinary income.
Types of Retirement Accounts
Let' discuss the most common types of retirement accounts. Additional accounts not listed here are 403 (b), defined benefit plans by employers, Rabbi Trust arrangements with employers, 457 plans. Additionally there are other types of qualified accounts for purposes other than retirement such as 529 savings plans (used for education) and HSAs (used for medical expenses). These types of accounts can be used in your retirement plan strategy as well.
Traditional IRA
When people think "tax-free" account, the most common one that comes to mind is the traditional IRA. Before Roth IRA's they were just called IRAs for Individual Retirement Account. They were originally designed to allow individuals to save money for retirement outside of their employers retirement options.
Contributions to IRA's are generally tax deductible, meaning they lower your taxable income, and therefore your taxes. But they are NOT tax-free. Rather you pay income tax on withdrawals, and if you don't take those distributions correctly, you can be subject to a withdrawal penalty.
Distributions from an IRA are subject to a 10% early distribution penalty if you are not 59.5. There are exceptions to this penalty such as if you are disabled or if you are the beneficiary of a deceased owner.
If the taxpayer is 70.5, they must begin distributions, called Required Minimum Distributions (RMD).
Roth IRA
Roth IRA's are a relatively newcomer. It essentially works in reverse of a traditional IRA. You do not receive a tax deduction for contributions to a Roth, but you don't pay taxes when you withdraw the money. Under current law distributions from Roth's are tax-free withdrawals.
Unlike traditional IRA's there are no RMD requirements. Just like a traditional IRA, as long as you don't take distributions, there is no tax due from increases in the value of the account.
The annual contribution limit for both traditional and Roth IRA's is $6,500 (2023) and $7,500 if the taxpayer is age 50 and over. These are the so called catch-up contributions.
SEP IRA
SEP, a type of employer-sponsored retirement plan, stands for Self Employed Pension. Unlike IRA's, these accounts were initially set up to give self-employed persons an alternative to save for their retirement.
While both IRA's have a fixed limit to the amount you can contribute in a tax year, the SEP allows a person to contribute up to 20% of income that is subject to self-employment (SE) tax up to $66,000 (2023).
Of course the SEP plan also has to cover other eligible employees in the business, which is an additional cost for the employer. For this reason, most businesses choose a 401k for their company. SEP's can be an option for sole-proprietors, those filing Schedule C.
The same 10% penalty for early distributions apply to SEP's.
SIMPLE IRA
SIMPLE IRA's were created as an alternative to 401k's for small business to provide retirement benefits to their employees. Changes have made them less appealing than a 401k for some employers, but you can't beat the low cost of SIMPLE plans.
Generally speaking there are no cost to establish or maintain a SIMPLE plan, unlike 401k's that require third party administrators for testing and compliance.
SIMPLE plans can be established by any business with fewer than 100 employees. Contribution limits for 2023 are $14,000 ($17,500 if the participant is 50 or over). The employer than has to match employee contributions dollar for dollar on the first 3% of the employees wages. Alternatively the employer contribution can be a 2% match of the salary for every employee, regardless of whether they contribute. Most employers don't choose that option.
Like IRA's there are penalties for early withdrawals, but there is a whooping 25% penalty if the distribution is within 2 years of first participation. Ouch!
401(k) Plans
401k plans were established during the pension reforms in 1970. They replaced the very expensive defined benefit plans that existed for large employers at the time. The idea was to shift the burden to the employers, and it worked.
Although usually seen with companies, self-employed individuals can also use them. Many small businesses find that 401k's offer the most bang for the buck with higher contribution limits than SIMPLE plans, and more flexibility than SEP plans.
401k's also have the added benefits of employee loans, allowing employees or business owners to access their money without having to pay early distribution penalties and income tax. There are additional costs paid to third party administrators (TPA's), but costs are coming down and affordable.
Employees (or owners) can contribute 100% of their salary up to $22,500 (2023), or $30,000 if they are 50 or over.
Eligibility Requirements for Tax-Free Retirement Accounts
For all qualified accounts, there are strings. These include eligibility limits.
Income Levels for Traditional IRAs
The only requirement currently to make a contribution to an IRA is that you have earned income, and the amount you can deduct for taxes is dependent on that earned income. Currently, there is no age restriction on who can make contributions to an IRA.
There are two limits to consider, however. The first is your income. For single taxpayers, if your modified adjusted gross income(AGI) is more than $68,000 (2023) your tax deduction is phased out. If your modified AGI exceeds $78,000 then you receive no deduction. AGI is a concept I discuss in this article, which makes adjustments to your taxable income like Social Security.
The second limit to consider is any participation you have in an employer's retirement plan. For married taxpayers filing status jointly, your tax deduction is phased out if your combined AGI is more than $204,000 and your spouse is covered by a retirement plan.
If you happen to contribute more to your IRA than are allowed to deduct for taxes, you can apply the contribution to a future year, but their can be penalties. Since you have until the filing date to make your contributions for the previous tax year, it is best to work with a tax professional before making your contributions.
Qualifying Income Levels Limits for Roth IRAs
Like traditional IRA's your contributions to a Roth are limited by your income. Single taxpayers can make a full contribution as long as their modified adjusted gross income(AGI) does not exceed $138,000. The contribution limit completely phases out for single taxpayers when their modified AGI exceeds $153,000.
How to Set Up a Tax-Free Retirement Account
Most financial institutions, including banks and credit unions, will allow you to setup both IRA and Roth IRA accounts.
SEP, SIMPLE and 401k accounts will have to be set up with a brokerage firm. Required documentation will depend on the type of account and the brokerage's requirements. Generally there will be no extra charge to setup those type of accounts. Remember, for a 401k will you need to engage the services of a third-party administrator, unless it is an Individual 401(k).
Choosing an Investment Vehicle For Your Contributions
Although there are some restrictions on the types of investments that these accounts can hold, generally, anything can be held as an investment, from cash to companies. You cannot sell property to a qualified account, and the account cannot purchase property for personal use. Some people use their IRA's to fund purchasing or starting a business, which is allowed.
People often ask if they can invest in gold in their IRA or other qualified account. The answer is yes as long is it is refined bullion and in the physical possession of the trustee (e.g. bank). Generally, the accounts cannot invest in a life insurance policy (annuities are allowed) or collectibles. Collectibles are things like artwork, rugs, antiques, etc.
When determining your investments, consider your risk tolerance, your expected investment returns, and tax liability. Your retirement portfolio should consider all aspects to be complete.
Conclusion
In conclusion, setting up a tax-free retirement account is a smart financial move that can provide you with peace of mind and security for the future. By taking advantage of the various options available, such as Roth IRAs or Health Savings Accounts, you can maximize your savings and minimize your tax burden. So, start planning for your golden years now and enjoy a worry-free retirement ahead!
