A 401k or 403b retirement plan is an employer-sponsored defined contribution plan that provides employees with an automatic way to contribute to a retirement savings account. When this benefit is offered to employees, most of the heavy lifting is done by the employer. The employer sets up the plan, provides investment choices within the plan, and they even connect contributions directly to payroll – making the employees participation extremely easy and simple to set up.
What if you want to start to save for retirement but you find yourself in a situation where you don’t have this type of benefit available? Maybe your employer has not set up a retirement plan yet? Maybe you are self-employed? To follow, I will discuss some of the ways you can contribute to your retirement if you don’t have a 401k or 403b.
First, I’d like to lay down some basic differences between “Roth” or “post tax” contributions and what are usually referred to as “traditional” or “pre-tax” contributions.
Pre-tax contributions refer to contributions to a retirement account that qualify for special tax treatment. These contributions will reduce your taxable income and therefore lower your tax liability in the year you made the contribution. But we all know that Uncle Sam will eventually want their share, so you will pay income taxes when you eventually take a distribution from the account.
On the other hand, Roth contributions will come from taxed income but the funds will never be taxed again, even the growth. I always recommend looking at your roth options first, especially if you are just starting your career and expect your income to increase steadily. The main reason for this approach is because of the income restrictions that the IRS puts on these contributions. In other words, once your income hits a certain level your ability to make contributions directly to a Roth IRA will be limited, and eventually eliminated completely.
Here are the different types of accounts you should consider and the advantages and disadvantages to each.
Roth IRA
This is a great place to start. The main consideration for the Roth IRA is your income. For 2022, the phaseout of contributions start at $129,000 and are eliminated at $144,000 for a single or head of household tax payer, or $204,000 to $214,000 for married filing jointly tax filers. The maximum amount the IRS allows you to contribute for 2022 is $6,000, and $7,000 for those over 50 years old. The advantage to these contributions is they will be made post-tax, but you will never pay taxes on these funds again.
Related: 4 Uses of a Roth IRA
Traditional IRA
If you are single and don’t have access to an employer sponsored plan, or you are married and neither you or your spouse have access to a 401K or 403b, then you automatically qualify to contribute the maximum to a traditional IRA. Like the Roth IRA, there will be a max contribution limit of $6,000, or $7,000 for those over 50 in 2022. If you are married and your spouse has access to a plan through their employer, your phaseout of tax deductibility of contributions will range from $204,000 to $214,000. You must also consider that IRA contribution limits are a combination of your traditional IRA and Roth IRA. For example, if you make a $3,000 contribution to your Roth IRA in 2022, you will only be able to make a $3,000 contribution to your traditional IRA in the same year ($4,000 if you are over 50).
Related: Essential Tax Tips for IRAs
SEP IRA
The SEP IRA or Simplified Employee Pension is a great consideration if you are self employed. In fact, to qualify to contribute to a SEP, you must be filing income from self employment. There are less restrictions on contributions and favorable tax treatment where you can contribute up to 25% of your self-employment income with a max of $61,000 for 2022 and reduce your taxable income. The IRS considers these plans employer plans and requires all employees to receive the same percentage of their income. In other words, this plan becomes more complex when you have employees because you will be required to make contributions on their behalf.
Solo 401K
This option is very much like a SEP IRA, but depending on your situation, it may provide some flexibility that will provide a greater benefit. Like the SEP IRA you need to be earning income from self employment. The structure of the plan will be just like an employer sponsored plan, where there will be employee contributions and the ability of the employer to make profit sharing contributions (sometimes in the form of a match). The maximum amount of employee contributions will be $20,500, or $27,000 for those over 50. The employer can make a tax deductible profit sharing contribution with a maximum total employee and employer contribution limit of $61,000, or $67,500 for those over 50. For example, let’s say somebody makes the maximum contribution of $20,500, the maximum employer contribution they can make will be $40,500. Of course, the company would have needed to have net income above that amount after earned income was distributed where the earned income was above $20,500.
There are many moving parts when it comes to deciding what’s the best direction to go to meet your needs. With that said, I would highly recommend consulting with both a financial advisor and a CPA through the decision-making process. We would be happy to set up a meeting to discuss your specific situation and needs, or answer any questions you may have.