IRA, 401(k), SEP IRA, 457 plan, 403(b) plan, SIMPLE IRA, Solo 401(k): This alphabet soup is Uncle Sam’s shorthand for some of the most popular retirement plans offered to working Americans.
Gone are the days when workers could count on an employee pension plan and Social Security to cover their costs during those golden years. Today, pensions are a rarity and Social Security isn’t a slam-dunk for future generations since we have an aging population and fewer workers paying into the system.
Because of this, Uncle Sam
wants needs YOU to save for retirement. Offering tax breaks on retirement plans is the government’s way of enticing us to set aside money and employers to help out.
Here are some of the options you might have when it comes to tax-advantaged retirement savings.
Types of retirement plans
There is no shortage of tax-advantaged retirement plans designed to help people save. The most common are:
- Individual retirement plans: Traditional IRAs, Roth IRAs, Spousal IRAs, myRAs, rollover IRAs.
- Employer-sponsored retirement plans (or defined contribution plans): 401(k)s, Roth 401(k)s, 403(b)s (or TSAs), 457(b)s, Thrift Savings Plans.
- Retirement plans for the self-employed and small-business owners: SEP IRAs, Solo 401(k)s/Solo Roth 401(k)s, SIMPLE IRAs, payroll deduction IRAs, profit sharing.
The IRA is the big kahuna of retirement savings plans. An individual can set up an IRA at a financial institution, such as a bank or brokerage firm, to hold investments — stocks, mutual funds, bonds and cash — earmarked for retirement.
The IRS limits how much an individual can contribute to an IRA each year, and depending on the type of IRA, decides how the funds are taxed — or protected from taxation — when a participant makes deposits and withdrawals.
Main advantages of IRAs
- They put you in the driver’s seat. You choose the bank or brokerage and make all the investment decisions, or hire someone to make them for you.
- Depending on the type of IRA you choose — Roth or traditional — and based on your eligibility, you decide how and when you get a tax break.
- IRAs provide a much wider range of investment choices than workplace retirement plans do.
- If you qualify for both a Roth and a traditional IRA in the same year, you can contribute to both! Your total contributions must remain below the maximum the IRS says you’re allowed to sock away. But the “two-fer” does get you some tax diversification in your retirement portfolio.
Main disadvantages of IRAs
- IRAs have lower annual contribution limits than most workplace retirement accounts: $5,500 per year versus $18,000 for 401(k)s, or for those over age 50, $6,500 versus $24,000 — in 2016.
- Roth IRA contribution limits are based on your modified adjusted gross income, and the amount you’re allowed to contribute begins to decrease for single taxpayers who make more than $117,000 and married, joint filers who make more than $184,000.
- Income, tax filing status and access to a workplace retirement plan affect how much of a traditional IRA contribution you can deduct. To qualify for a full deduction, single filers must have a modified adjusted gross income of $61,000 or less and joint filers must make $98,000 or less.
- Choosing between a Roth and a traditional IRA requires you to guess what your tax situation will be when you start drawing from the account.
Sources: IRS.gov, Fidelity.com, Schwab.com, Vanguard.com
401(k)s and other employer-sponsored retirement plans
Human resource departments cover a lot during new employee orientation. Pay close attention, because there may be a pot of gold — information about a workplace retirement plan — buried in the pile of paperwork you’ve been asked to initial and sign.
There are two main types of employer-sponsored retirement plans:
Defined benefit plans: Perhaps you’ve heard references to pension plans in black-and-white movies or when elderly relatives reminisce about the “good old days.” In olden times, some companies guaranteed workers a set benefit in retirement based on their years of service and average salary. The company kicked money into a single retirement pool and the pension plan invested it, hopefully earning enough to make good on its promise of retirement support. In these modern times, you might happen upon an employer that makes annual contributions to a retirement plan based on a similar formula, but without any promise or guarantee of the benefit provided in retirement.
Defined contribution plans: This type of plan is now the more common type of workplace retirement plan. Employers set up these plans, usually 401(k)s, to enable employees to contribute to an individual account within the company plan — typically via payroll deduction. If you come across the words “company match” in your benefits paperwork, that means you’ve hit the jackpot: an employer-sponsored retirement plan in which the company contributes to your account based on your personal contribution level (e.g., a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6%).
» MORE: 401(k) calculator
Main advantages of defined contribution plans:
- They’re easy to set up and maintain. Most employers offer an automatic payroll deduction option for deposits into the plan, and the retirement plan administrator (a separate financial institution) handles statements, disclosures and updates.
- Your employer might match a portion of your contribution. (This is free money!)
- 401(k) contribution limits are higher than those for IRAs.
- Employee contributions (to non-Roth plans) reduce your taxable income for the year. Because of that upfront tax break you’ll owe taxes on the withdrawals you make in retirement. Roth 401(k) contributions don’t offer any immediate tax break; contributions are made with after-tax money. However, withdrawals from the account are tax-free in retirement.
- The Roth 401(k) has no income restrictions, unlike the Roth IRA.
- Participant-directed plans give employees control of investments. You decide how much of your contribution to direct into each investment among the options within the plan.
Main disadvantages of defined contribution plans:
- Investment choices within employer-sponsored retirement plans are limited to certain funds, leaving you with fewer options than in a self-directed IRA. If you have limited retirement dollars, here’s how to decide if it’s better to invest in an IRA or a 401(k).
- Management and administrative fees can be high and dramatically erode investment returns over time. Use our FeeX 401(k) fee finder tool to find out how much you’re paying in fees in your retirement plan.
- New employees might have a waiting period before they can contribute to a plan (e.g., 30 to 90 days of employment).
- Employer contributions might be subject to a vesting schedule, in which money becomes the property of employees only after they have worked for the company for a certain amount of time.
Retirement plans for small-business owners and self-employed individuals
According a 2015 U.S. Department of Labor report, 34% of workers don’t have access to a workplace retirement plan. At companies with fewer than 100 workers, roughly half of employees are offered a retirement savings plan.
If you work at or run a small company or are self-employed, you might have a different set of retirement plans at your disposal. Some are IRA-based, while others are essentially single-serving-sized 401(k) plans. And then there are profit-sharing plans, which are a type of defined contribution plan.
Main advantages of plans for the self-employed:
- Plans for contractors, the self-employed and small-business owners have higher contribution limits than most employer plans and IRAs.
- These plans often offer more investment choices than employer-sponsored plans, such as 401(k)s.
- Many of these plans are easy to set up and therefore not much of a burden on the employer — that’s you, if you’re a small-business owner.
- You might be able to set up your account at a financial institution you already use.
- If you’re self-employed, you can give yourself a generous profit-sharing contribution, plus make your elective deferral — with catchup — as the employee.
Main disadvantages of plans for the self-employed:
- Employer contributions might be completely discretionary, putting more of the savings burden on employees/plan participants.
- Setup and administrative duties for more complicated plans fall to the employer — which might be you.
- Some plans have narrower parameters for allowable early withdrawals than traditional IRAs and employer-sponsored retirement plans.
- Loans from some plans must meet certain requirements and require the participant to apply.
- For the self-employed, the profit-sharing cap boils down to about 20% of net profits because of Federal Insurance Contribution Act taxes due on net profits.