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Key takeaways:
- There are many different types of retirement plans; you can mix and match to meet your specific needs.
- Take full advantage of any matching funds available to you; it’s free money that will boost your savings.
- Even if you’ve contributed the maximum amount allowed by the IRS to a tax-advantaged retirement plan, you can still save with a taxable account. The combination gives you flexibility in terms of taxes, distribution requirements, and timing.
We all know that saving for retirement is important, but did you also know that there are many different types of retirement savings plans? All offer advantages—you may even be able to participate in more than one at a time—which means there’s something for everyone.
Savings plans vary in terms of who contributes money (you, or you and your employer) and in their tax advantages (whether you are taxed at the time you make the contribution or when you withdraw the money). Smart savers take full advantage of what’s available to them, and then mix and match plans to diversify their income sources during retirement.
Here is a high-level overview of some of the most common types of retirement plans.
Employer-sponsored retirement accounts
With these plans, both you and your employer contribute a percentage of your salary to an account in your name. The value of your account changes over time according to how the fund is invested. Saving is automatic; the contributions are taken directly from your paycheck, which means you pay yourself first. When you retire, you take distributions from the account balance, which includes what you put in plus or minus the gains or losses you made from the fund’s investment over time.
401(k)
With a 401(k), you set aside part of your salary and often, although not always, an employer will match your contributions to a certain percentage. For example, your employer may add $1.00 for every $1.00 you contribute, up to 3% of your earnings. Financial professionals strongly encourage that you take full advantage of this match, because it’s basically free money. The money you contribute is always yours, but there may be vesting rules that determine how much of the matching funds are yours based on your length of employment with the company.
The IRS limits the amount you may contribute to a 401(k) each year, although if you’re 50 years or older, you are eligible to make additional ‘catch-up’ contributions. Most 401(k) plans offer a range of investment options that allow you to choose the amount of risk you want to take on; you can shift your money between investments if you wish.
You must leave your money in the 401(k) until at least age 59-1/2, or you’ll pay a penalty. The IRS requires that you begin withdrawals (called required minimum distributions or RMDs) at age 72. Many but not all 401(k) plans allow you to borrow against your balance, although there are drawbacks to doing so.
There are two types of 401(k) plans:
Traditional 401(k)
Contributions to a traditional 401(k) are taken from your paycheck before your taxable income is calculated. This reduces your income and therefore the amount of income tax you must pay. You are then taxed when you withdraw money from the account; this benefits most people because they are typically in a lower tax bracket during retirement.
Roth 401(k)
This option works like a traditional 401(k) except your contributions are taken from your salary after tax; then when you withdraw the money during retirement, your money and earnings are tax-free. Roth rules are beneficial if you expect to be in a higher tax bracket in retirement. If your employer offers both a traditional and a Roth 401(k), you may be able to contribute to both, but your maximum contribution is still limited by the IRS.
While there are income limits that determine who can contribute to a Roth IRA, anyone can contribute to a Roth 401(k). But unlike a Roth IRA, which has no RMDs once you turn a certain age, a Roth 401(k) does have distribution rules for retirees aged 73 or above. This requirement will change in 2024. Historically, if you were contributing to a Roth 401(k), matching contributions from your employer were put into a traditional 401(k), which meant you’ll pay tax on those matching funds when you take the distribution. This will also change in 2024; you will be able to choose whether you want your matching dollars designated as traditional or Roth.
403(b)
Sometimes called a tax-sheltered annuity, this retirement plan works like a 401(k) except it is offered to employees by nonprofits such as hospitals, public school, churches, and other tax-exempt organizations. As with a 401(k), employees make pre-tax contributions to their own account; matching contributions may also be made by some employers. Like a traditional 401(k), your money is taxed when you take distributions during retirement. Investment options are narrower than with a traditional 401(k)—limited to annuities and mutual funds—but they also tend to have lower fees. If you have 15 or more years of service, you may qualify for catch-up contributions, which could give you extra saving power.
457(b) and Thrift Savings Plan (TSP)
A 457(b) is a retirement savings program for employees of state and local governments, while the TSP is designed for federal government workers. Operating like a traditional 401(k), these plans let you contribute pre-tax dollars, which reduces your taxable income and therefore the amount of income tax you must pay. You are taxed when you withdraw the money during retirement. Like a 403(b), your investment options for these plans are typically limited to mutual funds and annuities. Some large government employers offer a 457(b) in addition to a 401(k); you may be eligible to contribute to both. In some cases, federal government employees may be eligible for matching funds even if they don’t make contributions of their own to the TSP.
Individual retirement accounts (IRAs)
Individual retirement accounts are just that—individual—which means you are the only one contributing to the account. But you also get to call all the shots. IRAs give you a wider range of investment choices than an employer-sponsored retirement account, and you can set up an IRA with a brokerage or investment firm. You may be able to contribute to both a traditional and a Roth IRA in the same year, which gives you tax diversification when it comes time to withdraw your money, but the total amount of your contributions is limited.
Traditional IRA
Like a traditional 401(k), the contributions you make to a traditional IRA are tax-deferred, which means you aren’t taxed until you withdraw the money during retirement. This feature benefits you if you think you’ll be in a lower tax bracket once you retire (which is typical for most, although not all, people). Anyone can set up a traditional IRA, but you are limited in how much you can contribute each year. Once you turn 73, you will be subject to RMDs; at that point, you will be taxed on the distributions.
Roth IRA
With a Roth IRA, you pay income taxes on the money before it is set aside in the account, but when you withdraw the money and earnings, it is tax free. Not everyone qualifies to contribute to a Roth IRA; contributions are only available for those earning less than a certain amount per year. With a Roth IRA, you are not subject to RMDs once you turn 73, which gives you more flexibility in terms of when you receive distributions during retirement.
Spousal IRA
If your spouse is not working and you file a joint tax return, this IRA option allows him or her to still contribute to a tax-advantaged retirement savings account. A spousal IRA can be established as either a traditional or a Roth version; contribution limits are the same.
Small business and self-employed retirement accounts
If you’re self-employed, if you run a small business, or if you work for a small business, you still have retirement savings plan options.
Solo 401(k)
This plan, which can be configured as a traditional or a Roth 401(k), is for people who own a business but have no employees. The Solo 401(k) plan allows you to contribute to your retirement savings both as an employer and as an employee, giving you extra opportunities to save. For example, if your annual income was $20,000, you could contribute 100% of that as an employee (or more if you’re age 50 or older), and then you could contribute again as the employer by adding an additional 25%. Contribution limits apply, but this option may allow you to put away more towards retirement savings than you can with other options like a SEP IRA.
SIMPLE IRA and SIMPLE 401(k)
SIMPLE (Savings Incentive Match Plan for Employees) IRA or 401(k) plans are for businesses with 100 or fewer employees; you can even set up a SIMPLE account if you’re self-employed. Companies offering a SIMPLE 401(k) or IRA are required to either match an employee’s contribution up to 3% or directly put 2% of an employee’s pay into the account. Like with a traditional 401(k) or IRA, your employee payments to a SIMPLE plan are made pre-tax. Contributions limits are lower than for non-SIMPLE plans, but catch-up contributions are allowed.
SEP IRA
A Simplified Employee Pension Plan (SEP) is another good option if you are self-employed or if you work for a company with just a few employees. A SEP operates like a traditional IRA, but you can contribute up to 25% of your net self-employment income or annual income (to a certain limit), which may be higher than the traditional IRA limits. Contributions and earnings are tax-deferred, which means that they won’t be taxed until you withdraw your money during retirement.
Taxable investment accounts
A taxable investment account may be a good option if you want to save more than the IRS allows in a tax-advantaged retirement account, or if you don’t have access to a 401(k) or other retirement savings plan where you work. A taxable account also gives you the flexibility to take distributions without penalty if you decide to retire early. You can invest in stocks, bonds, mutual funds, and other options, giving you a great deal of choice to balance your portfolio. Tax diversification is another benefit; these accounts offer long-term capital gains tax rates that are typically lower than an income tax rate, which may be beneficial to you during retirement.
What type of retirement plan is best?
This is a trick question because no single type of plan is best. The right mix depends on your unique needs; all offer advantages, and you may even be able to make contributions to multiple types of retirement plans at once. Certainly, if your employer offers a company match, take full advantage of this free money. And if you’ve contributed the maximum allowable to your 401(k) or IRA, don’t forget that you can still contribute to a taxable retirement investment account.
Final thoughts
There’s no doubt that retirement savings can be complicated. There are so many ways to mix and match, optimizing your tax savings while building a portfolio that gives you accessibility when you expect to need the money during retirement. The most important thing to remember is that you should take full advantage of every opportunity you have to save, especially if you have an employer who offers matching funds. And even if you don’t have access to a tax-advantaged retirement savings plan, or if you’ve maxed out your IRS-allowed contributions, you can still save using a taxable investment account.
