Should I Contribute to the Retirement Plan at Work? (Part 2)
Continuing from Part 1, here are a third and fourth scenario in which it might make sense to contribute to a workplace retirement plan.
(3) You want to lower your tax bill for the current year further than you could with a Traditional IRA
Quite simply, the 401(k), 403(b), 457(b), and TSP allow you to sock away much more than a Traditional IRA. The differences are the same as between a Roth 401(k), etc. and a Roth IRA: $18,500 (plus an additional $6000 starting the year you turn 50) for the workplace plans, compared to just $5500 (plus an additional $1000 starting the year you turn 50) for the Traditional IRA. (Just to be clear, $18,500 (plus an additional $6000 starting the year you turn 50) are the total limits for pretax and Roth contributions combined in a workplace plan. In other words, every dollar you contribute on the pretax side means one less dollar you can contribute on the Roth side, and vice versa. Similarly, $5500 (plus an additional $1000 starting the year you turn 50) are the total limits for all Traditional and Roth IRA contributions combined.) Hence, the workplace retirement plans allow you a much larger tax write-off for the year in which you’re contributing. So, for example, if you or your accountant project that your taxable income this year will push you into a higher tax bracket, a workplace plan will give you more leeway than a Traditional IRA to lower that taxable income.
Then there’s the fact that in certain situations, a Traditional IRA won’t offer you any outlet to save on taxes for the current year. For example, if you or your spouse have access to any type of retirement plan at work (including a pension), then depending on how much money you make, some or even all of your contributions to a Traditional IRA might not be tax-deductible. (You can still make the contributions, and taxes on the profits will still be deferred until later. You just won’t get the up-front tax break. See here and here for more detail.) Another scenario in which a Traditional IRA won’t help you is if you’ve reached the age of 70½. At that point, money is no longer allowed to flow in to a Traditional IRA; it can only flow out. (Thankfully, the same is not true of a Roth IRA!) But if you’re still working at that point and have access to a 401(k) or similar plan, then not only can you continue putting money into it (on either the pretax or Roth side), but you can also delay RMDs (required minimum distributions) from that plan until you part from the employer. (If the employer is a company in which you own a 5% or more stake, then you can’t delay the RMDs, but you still can put money in after 70½.)
This is a good place for me to mention that some workplace retirement plans provide an opportunity for you to go “off-menu” and invest in a self-directed brokerage account in addition to (and possibly even instead of) the plan’s menu of mutual funds. Mind you, this account will be with a brokerage firm selected by your employer for all plan participants; you don't get to choose which firm you go with. This means you have to be willing to accept their commissions and transaction fees, as well as any restrictions in terms of what you can buy and sell within the account. For example, your choices might be limited to ETFs and mutual funds. But you'll still have a broader selection of investment opportunities than just the plan's core menu of mutual funds. (DISCLAIMER: I wouldn't recommend opening a self-directed account inside your workplace plan unless you're working with a dependable trading/investing system, whether it's a system you've developed yourself, a service you subscribe to that advises you on trades/investments to make, or a third-party money manager who's authorized to make the trades/investments in the account on your behalf.)
If you’re not sure if your employer’s plan gives you the option to set up a self-directed brokerage account, check the plan’s summary plan description (as described last time). The account might go by a brand name, such as “BrokerageLink” from Fidelity or “Personal Choice Retirement Account” from Charles Schwab. If you have an online copy of the summary plan description, you can search the document for terms like “self-directed”, “brokerage”, or “SDBA”.
(4) You own a business with no employees (other than your spouse)
If this applies to you, and you’d like to shield more of your business income from current and/or future taxes than a Traditional or Roth IRA would allow you to, then you should look into establishing your own personal 401(k), commonly known as a solo 401(k). This is essentially the same as a regular 401(k), but with some key advantages. First, there’s less paperwork. (You don’t have to prove to the Department of Labor that you’re treating your employees fairly, because you don’t have any!) Second, you get to play the role of both employer and employee. As an employee, you (and your spouse if they’re an employee of the business) can make pretax and/or Roth contributions up to the same limits as if you were an employee of someone else’s business, and then on top of that, as the employer, you can "share" a certain percentage of the business’s cash flow with yourself (and your spouse if they’re an employee of the business) and write those payments off as business expenses! (Of course, as an employee, you’ll have to pay income tax on those “profit-sharing” payments when you cash them out down the road.) The third advantage of a solo 401(k) is that you can set it up as a self-directed account, giving you way more freedom to invest how you like than a 401(k) you could get as someone else’s employee. In short, a solo 401(k) can make a fantastic addition to your financial plan.
By the way, instead of a solo 401(k), a solopreneur could opt for a SEP IRA, which is even easier to set up and may cost less to set up and maintain. However, be advised that a SEP IRA only allows pretax contributions, and depending on your age and how much income the business generates for you, your ability to contribute to a SEP IRA each year could be capped at a lower amount than a solo 401(k). Conversely, if you’re looking to sock away even more money than a solo 401(k) would allow, consider establishing a defined benefit plan. I’ll talk more about SEP IRAs and defined benefit plans in a future post!
More to come!