In this video, we walk through 5 TCP practice questions teaching about the advantages and disadvantages of different retirement accounts. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Advantages and Disadvantages of Different Retirement Accounts
When planning for retirement, choosing the right retirement account is crucial as it directly impacts financial security during one’s retirement years. In this overview, we’ll delve into the various retirement accounts discussed—Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs—highlighting their advantages and disadvantages to provide a comprehensive understanding to help in preparing a decision-making schedule.
Traditional IRAs (Individual Retirement Account):
Advantages: Traditional IRAs are appealing due to their tax-deferred growth and tax-deductible contributions. Contributions made to a Traditional IRA can reduce an individual’s taxable income in the year they are made, effectively lowering their current tax bill. This can be particularly beneficial for those in higher tax brackets.
For example, if someone in the 22% tax bracket contributes $6,000 to their Traditional IRA, they could reduce their tax bill by $1,320 for that year. Moreover, the investment growth in a Traditional IRA is not taxed until withdrawals begin, typically during retirement when the individual may be in a lower tax bracket.
Disadvantages: The primary drawback of Traditional IRAs is that withdrawals in retirement are taxed as ordinary income, which could result in higher taxes if the retiree remains in a high tax bracket. Additionally, there are required minimum distributions (RMDs) starting at age 72, which can force withdrawals even if the income is not needed, potentially leading to higher taxes. Early withdrawal penalties also apply, as taking money out before age 59½ incurs a 10% penalty plus taxes on the amount withdrawn.
Roth IRAs:
Advantages: Roth IRAs offer tax-free growth and tax-free withdrawals in retirement, which is a significant benefit for those who anticipate being in a higher tax bracket later in life. Contributions to a Roth IRA are made with after-tax dollars, meaning the money grows and can be withdrawn tax-free. A unique advantage of Roth IRAs is the ability to withdraw contributions (not earnings) at any time without penalties, offering flexibility not typically found in other retirement accounts. This makes Roth IRAs an excellent choice for long-term growth and flexibility.
Disadvantages: The main disadvantage of Roth IRAs is that contributions are not tax-deductible, providing no immediate tax break for contributions. Moreover, there are income limits which may prevent high earners from contributing directly to a Roth IRA, although backdoor Roth IRA strategies can sometimes be used to circumvent this issue.
SEP IRAs (Simplified Employee Pension):
Advantages: SEP IRAs are favored by many self-employed individuals and small business owners because of their high contribution limits—for example, it was up to 25% of income or $61,000 in 2022, whichever was less. This allows for significant tax-deferred savings. The administrative requirements for SEP IRAs are also relatively low compared to other employer-sponsored plans, making them easy to manage.
Disadvantages: A significant limitation of SEP IRAs is the requirement to make proportional contributions for all eligible employees if the employer contributes to their own SEP IRA. This can become a substantial financial obligation as the business grows or during profitable years.
For instance, if a business owner contributes 10% of their own salary to a SEP IRA, they must also contribute the same percentage to their employees’ SEP IRAs, which can quickly escalate in cost.
SIMPLE IRAs (Savings Incentive Match Plan for Employees):
Advantages: SIMPLE IRAs are designed for small businesses with fewer than 100 employees and offer both employer and employee contributions, enhancing retirement savings potential. Employers are required to either match employee contributions up to 3% of their salary or contribute 2% of each employee’s salary regardless of the employee’s contributions. Contributions are immediately 100% vested, which can improve employee retention and satisfaction.
Disadvantages: The primary downside of SIMPLE IRAs is their lower contribution limits compared to other plans like 401(k)s and SEP IRAs. For example, in 2022, the contribution limit was $14,000 for those under 50. Additionally, the mandatory nature of employer contributions can pose a financial burden, especially during lean years. Moreover, employees and employers face a 25% penalty for withdrawals within the first two years of participation, which is significantly higher than the penalties associated with other retirement plans.
