Having a sound retirement strategy is an important component of good tax planning.  There are many different types of retirement plans that can provide you or your employees with substantial annual tax benefits.  This blog post outlines the various types of retirement plans and touches upon some of the tax benefits associated with each of them.

Defined Benefit Plan

Under the traditional defined benefit or pension plan, the employer pays the employee a specific amount of compensation each month after the employee retires.  The amount of compensation received by the employee after retirement is usually based upon a combination of the number of years worked and the average of the highest three consecutive years of the employee’s salary. 

Some defined benefit plans, such as cash balance pension plans, involve an employer crediting the employee each year with a percentage of their annual salary plus interest.  This amount is deposited into an account and the employer invests that money as it see fit.  Upon retirement, the employee has the option of taking the balance in one lump sum or converting it into an insurance product called an annuity. 

Employers offering defined benefit plans are permitted to deduct their annual contributions to the plan which can result in significant tax savings.  However, defined benefit and pension plans are becoming a thing of the past as companies are moving to less expensive options.

Traditional Individual Retirement Account (IRA)

A traditional IRA is a personal savings account that allows the holder of the account to set aside a certain amount of money every year that is tax-sheltered.  Not only is the money that is deposited each year into the account tax deductible, but the earnings in the account also grow tax deferred until they are distributed.  Another advantage of an IRA is that one can have an IRA account even if they are also covered under another retirement plan.  However, individuals who are also covered by an employer-based plan may not be eligible to fully deduct their annual contributions to an IRA account.   

There are annual contribution limits to an IRA.  For 2010, an IRA holder can contribute up to $5,000, or their taxable compensation for the year, whichever is lesser.

Roth IRA

Much like a traditional IRA, a Roth IRA is a retirement savings fund with tax advantages.  What makes a Roth IRA different than a traditional IRA is that annual contributions to a Roth IRA are nondeductible.  The advantage of a Roth IRA is that in most cases the earnings accrued and distributions received from the account are entirely tax-free.  As with the traditional IRA, the maximum contribution level allowed by a Roth IRA account holder in 2010 is the lesser of $5,000 or the taxable compensation for the year.

Employer-Sponsored Plans

There are several different types of employer-sponsored retirement plans that have both a salary deferral component and an employer contribution component to each of them.  Some of the more popular plans include the 401(k), the 403(b) and the SIMPLE plan.  These plans allow the employee to defer a percentage of their monthly compensation to a retirement fund.  The employer also makes a contribution to the retirement fund on the employee’s behalf.  Both the contributions of the employer and the employee are not taxed until the funds are withdrawn. 
By electing to defer compensation under an employer-sponsored program, the employee is able to reduce their taxable income each year.  Also, because the maximum contributions limits to employer-sponsored plans are much larger than what is allowed under other plans, the tax benefits associated with an employer-sponsored plan are more significant.  

If you are an individual who make substantial annual income or a small business owners offering a retirement plan to your employees, it is highly recommended that you have your individual situation analyzed by an experienced tax professional.  The tax attorneys and tax professionals at the Law Office of Stephen Moskowitz, LLP are skilled in analyzing which combination of retirement plans are right for you or your business.  Call us today at 1-800-829-3327 for an attorney-client consultation and find out how we might be able to save a great deal more on your taxes each year.