If you are making contributions to a Simplified Employee Pension (SEP) or some other kind of pension plan, you may want to understand how your contributions work from a tax perspective. While many pension plan contributions get the benefit of being tax-deductible, not all contributions are. Knowing this prior to filing your taxes will prevent you from making a mistake on your tax return.
Qualified Pension Plans
Qualified pension plans are pension plans that provide tax benefits on all contributions going into the plan. These plans allow you to contribute tax deductible or pretax contributions to the plan. Examples of this type of plan are SEP and SIMPLE IRAs. These plans are employer-sponsored plans in which your employer contributes money to the plan along with you, similar to defined contribution plans like 401(k) plans. You may invest the money any way you choose according to the investments available at the financial institution managing your plan.
Non-qualified plans are retirement plans, like annuities or non-qualified deferred compensation plans, that only accept non-deductible contributions. The contributions to the pension may also be made entirely by the employer. But, in either case, the pension plan contribution is funded with after-tax dollars and is not deductible.
The benefit of tax deductible contributions to a pension plan is that you get more money to invest now. Because your contribution is deductible, you may end up with a larger total retirement savings at retirement. Non-deductible contributions leave you will less money to invest right now, but may provide you with more income later. This is because contributions that are taxed now won't be taxed in the future when you withdraw the money. Only the investment gains will be taxed. Even though the contributions are the same as deductible contributions, your net income may be higher than deductible plans because of this.
Before deciding what kind of pension you want to contribute to, you should analyze your financial goals and expected future income. In many instances, you won't have a choice. Your employer will offer you a particular plan and that's it. What you'll need to decide is whether the plan will be beneficial for you in the future. If you expect to be in a high tax bracket in the future, you'll want to opt for a plan that minimizes future taxes. A non-qualified plan might be ideal. But, if one is not available, then you might want to consider a Roth IRA or a plan outside of your company's pension offerings.
- "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007
- IRS: Publication 575
- Photo Credit Photodisc/Photodisc/Getty Images
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