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Qualified Retirement Planning: Tax Advantages & Disadvantages

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Advantages and Disadvantages of Tax-Free and Deferred-Tax Retirement Plans

What are “qualified retirement plans” and how can they be effective for tax planning?

Well, there are plenty of tax savings advantages to individuals contributing to tax-free retirement accounts, as well as tax-deferred retirement accounts. However, this doesn’t necessarily mean that there are no disadvantages because as the saying goes, there are only trade-offs, no solutions.

Let’s walk through some of the key differences in the advantages vs disadvantages to contributing to a qualified retirement account:

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What Does Tax Deferred Mean?

“Tax deferred” refers to investments on which accrued taxes are payable at a future date instead of in the period in which they are earned. 

What’s the purpose, you ask? Imagine giving your dollars a “grow now, pay later” deal.

How It Works:

When you invest in a tax-deferred account, such as a traditional IRA or a 401(k), you don’t pay taxes on the money you contribute today. Instead, you’ll pay taxes on the money when you withdraw it, typically during retirement. The beauty of tax deferral is that it can help your savings grow faster, because the money that would have been taken out for taxes remains invested and compounds over time.

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Advantages

Qualified retirement plans provide the benefit of pretax contributions, allowing individuals to invest a portion of their earnings into a retirement account before taxes are assessed. This can effectively lower an individual’s taxable income and defer tax liability on the invested funds until withdrawal.

 

Other Advantages:

Some of the other advantages to qualified retirement planning include the following:

Tax-Deductible Contributions: Contributions to certain retirement plans, such as Simplified Employee Pension Individual Retirement Arrangements (SEP IRAs) by self-employed individuals, are tax-deductible. This deduction reduces the individual’s taxable income for the year in which the contributions are made.

Tax-Deferred Accumulation of Earnings: Investment earnings in a qualified retirement plan accrue on a tax-deferred basis, meaning taxes on the earnings are postponed until funds are withdrawn during retirement. This deferral can significantly enhance the potential compound growth of the retirement savings.

Asset Protection from Creditors: Qualified retirement plans typically offer protection against claims by creditors, ensuring that assets within these plans are shielded in cases of financial adversity. This protection is crucial in safeguarding an individual’s retirement assets.

Avoidance of Probate: Assets held within qualified retirement plans such as 401(k)s or IRAs are transferable to designated beneficiaries outside of the probate process. This allows for a more efficient and private transfer of assets upon the account holder’s death, avoiding the time and expense associated with probate proceedings.

Qualified retirement plan advantages example Casey receives a $5,000 paycheck every two weeks
Qualified retirement plan advantages example Casey contributes $1,000 per month to her retirement plan
Qualified retirement plan advantages example

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  5. Qualified Retirement Planning: Tax Advantages & Disadvantages

Disadvantages:

While qualified retirement plans offer numerous advantages, they also come with certain drawbacks. Distributions from these plans are typically taxed as ordinary income, not as potentially lower long-term capital gains. Furthermore, the assets within these plans are not immediately liquid and early withdrawals may incur penalties, although there are some exceptions to this rule, such as for qualifying hardships or after reaching the age of 59 ½.

Disadvantages of Qualified Retirement Plans

Disadvantages include:

Distributions are taxed as ordinary income rather than long-term capital gains. If instead, you invested your cash into a normal brokerage account, the accumulated earnings would be taxed at a lower long-term capital gains rate if held for over a year.

Qualified retirement plans are illiquid assets, meaning you cannot distribute from your qualified retirement plan until your age of retirement (59 1/2) without incurring a penalty tax.  

Disadvantages of qualified retirement plans includes trade-off of having to wait until the age of retirement
Disadvantages of qualified retirement plans includes illiquid assets

Most Common Qualified Retirement Plans:

While there are countless retirement plans that an individual taxpayer may choose from, you should be familiar with the four primary qualified retirement plans tested on the CPA Exam. These include the following:

 

Employee-sponsored Section 401(k) Plans

Allow employees to make pre-tax contributions from their salary.

Employers may offer matching contributions to employee accounts.

The plans often include a variety of investment options and have tax-deferred growth on earnings.

 

Traditional IRAs (Individual Retirement Accounts)

Provide a way for individuals to contribute pre-tax income towards their retirement savings.

Contributions may be tax-deductible depending on the individual’s income and participation in other retirement plans.

Taxes on the investment gains are deferred until the funds are withdrawn during retirement.

 

Roth IRAs

Funded with after-tax dollars, providing no tax deduction for contributions.

Distributions in retirement are generally tax-free, including the earnings, as long as certain conditions are met.

No required minimum distributions at a certain age, offering more flexibility in retirement planning.

 

Annuity Contracts

Contracts between an individual and an insurance company that provide a stream of income in retirement.

Contributions are made with after-tax dollars, and earnings grow tax-deferred.

Annuities can be structured to provide payments for life, offering a predictable income stream in retirement.


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