Retirement plans and accounts: which is right for you?

01 retirement plans and accountsBuilding wealth for retirement can be done in many ways, such as after-tax investments, real estate and tangible assets, insurance, and retirement accounts. This article focuses on retirement accounts to help you make the most of what you allocate to this powerful asset.

What is a retirement plan?

You might start your retirement planning process by defining what your retirement will look like and what it will cost. Next comes determining the resources available over the remaining years to see if your ideal retirement lifestyle is affordable based on what you have saved and how much more wealth you can accumulate.

A substantial portion of excess income is typically invested in retirement accounts, also called retirement plans. These are employer-based or individually established programs opened in financial institutions under the IRS’s approved guidelines.

Retirement plans are tax-advantaged accounts, and contributions are made either with pre-tax or after-tax dollars. With pre-tax dollars, you take a tax deduction upon contribution but pay tax later. With after-tax dollars, you don’t take a tax deduction upon contribution, but you pay no tax later. Funds are invested while in the account and are withdrawn ideally in retirement — or at least after age 59½ to avoid a tax penalty for early withdrawal.

How many retirement plans are there?

The IRS lists over a dozen types of retirement plans on its IRS.gov website. However, not everyone is eligible for all plans. Instead, your selection depends on many factors established by the IRS.

Understanding the plan you choose is essential, whether through the summary plan description your employer provides or the details provided by the financial institution, life insurance company, mutual fund, or brokerage that helps you with individual accounts. The best retirement plan allows you to maximize your benefits and ensure your financial well-being during retirement.

Is there a best plan?

Defining a “best plan” is not so easy. Circumstances differ for each of us, but the best plan for you will reflect three things:

  1. What is available to you based on your employment

  2. What you can set up as an individual

  3. The IRS-established limits to contributions across different types of retirement plans

Ideally, you should first contribute the required amount to capture any employer-match contributions if it is offered in your employer-based 401(k) plan, at minimum.

Next, you would contribute the maximum to an Individual Retirement Account (IRA), where you’d start contributing if you had no 401(k) available. Lastly, if you own a small business or are self-employed, some specific retirement accounts are designed for your needs, including SEP IRAs, SIMPLE IRAs, and Solo 401(k)s.

To help you design your strategy, we’ll explore each available option.

Employer-sponsored plans

When America began to industrialize, employers turned to defined benefit plans — or pensions — to provide for their workers’ old age. Companies funded retirement pools and invested the money to make regular payments to their retirees until they died.

Today, other than in government and union jobs, defined benefit plans have all but disappeared. The U.S. Bureau of Labor Statistics reports that 67% of private industry workers had access to employer-sponsored retirement plans in early 2020. Of those, 52% had access to defined contribution plans, 12% to defined benefit and defined contribution plans, and only 3% to defined benefit plans.

Defined contribution plans, also called retirement plans or retirement accounts, come in various forms. Although most plans are similarly structured, they can vary by:

  • Who is eligible

  • Whether employers offer to match

  • If there is vesting (or waiting for eligibility)

  • How funds are invested

  • How and when funds can be withdrawn

  • What is taxable upon withdrawal

Thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act passed in 2019, nearly three-quarters of plans now also allow salaried and hourly part-time employees to participate.

Next, we’ll explore the different types of employer-sponsored retirement plans at a high level.

401(k)

If you work for a company, your employer may offer one of the best ways to save and grow your funds for retirement: a 401(k) plan. With a traditional 401(k), you contribute part of your pre-tax earnings to the plan. Your money is invested and grows tax-deferred until you withdraw it, at which time you pay the federal and state tax on your withdrawals on contributions and earnings at your current tax rate. However, if you are under 59½ when you withdraw funds, you will pay a 10% penalty on top of the taxes due unless you qualify for an exception for reasons such as total disability, child support, and unreimbursed medical expenses — among others.

Maximum pre-tax 401(k) contributions for 2023 are $22,500, with a catch-up amount of an additional $7,500 for employees 50 and over.

Automated payroll deductions simplify 401(k) contributions. Check to see if your employer’s plan may match your contributions which, obviously, is an added bonus. Cons to an employer-sponsored 401(k) plan include the possibility that you may not be able to borrow funds from the plan before withdrawal in addition to potentially a limited number of investment vehicles available in your plan.

Roth 401(k)

If you work at a company and believe your current tax rate may be lower than when you plan to withdraw the funds at retirement, the Roth 401(k) could be for you. It’s a variation of the traditional 401(k), but you contribute after-tax dollars. In return, you pay no tax on your contributions or gains when you withdraw, so long as you are 59½ or older and have had the account for five years.

Just like a 401(k), maximum after-tax contributions to a Roth plan for 2023 are $22,500, with a catch-up amount of $7,500 for employees 50 and over.

Pros of the Roth 401(k) include the freedom from taxes when you need the funds most: in retirement. You also are not subject to pay required minimum distributions (RMDs) starting at age 72 because you already paid the taxes on your contributions. You can also withdraw contributions (but not gains) at any time without triggering penalties. Alternatively, cons include having to choose investments from among the sponsor plan’s options.

403(b)

If you work in public school systems, hospitals, charities, or other nonprofit organizations, the 403(b) is your version of the 401(k), and it works the same way. You contribute pre-tax money, your funds grow tax-deferred until retirement, and you pay taxes as ordinary income on the contribution and earnings upon withdrawal.

Just like traditional and Roth 401(k) plans, maximum 403(b) contributions in 2023 are $22,500, with a catch-up amount of $7,500 for employees 50 and over. The maximum combined employer contribution and employee salary deferral is $66,000 or 100% of the employee’s includable compensation.

403(b) pros include the ease of participation, as your money’s deductions and investments are automatic. Your employer’s plan may match your 403(b) contributions according to a formula, and your plan may allow you to take a loan if you need the money. Cons include occasional difficulty accessing your money in an emergency without triggering penalties and taxes. Also, investment choices are limited to the plan’s list.

457(b)

If you work for state and local governments or some tax-exempt organizations, the 457(b) plan is designed for you. Again, it functions like a 401(k) plan. What differs is that you can withdraw funds if you retire or leave your job before age 59½ without incurring an early-retirement 10% penalty.

Maximum contributions in 2023 are $22,500, with a catch-up amount of $7,500 for employees 50 and over.

Pros to the 457(b) are the penalty-free early withdrawal, plus some plans allow twice the annual catch-up contribution for the three years before retirement. Cons include the absence of employer matching and limited investment options: typically only annuities or mutual funds.

Less common retirement account options

Besides the four types of employer-sponsored retirement plans, employers may choose among three others.

If you work for one of the rare companies that still offer defined benefit pension plans, the company will make all the contributions and investment decisions. Then, once you retire, it will disburse a fixed monthly check determined by your income and your years of service. Even in retirement, you will have no control over the funds, but you will receive a check for life, barring some unforeseen event wiping out the pension fund.

If you work for a small business, it may offer you a Simplified Employee Pension (SEP IRA) plan. A SEP IRA is similar to a traditional IRA regarding investment, distribution, and taxation but offers far more generous contribution limits. Maximum contributions for 2023 are the lesser of 25% of your eligible compensation or $66,000.

If you work for an employer with 100 or fewer employees, you may be offered a Savings Incentive Match Plan for Employees (SIMPLE) IRA. You would contribute pre-tax dollars, and your employer would make mandatory contributions of up to 3% of your compensation or a fixed 2% contribution. Maximum contributions in 2023 are $15,500 for you, with a catch-up amount of $3,500 for employees 50 or over.

IRAs (individual retirement accounts)

An individual retirement account (IRA) is a long-term savings instrument used to accumulate retirement funds in a tax-advantaged environment. If you work in a company that does not offer employer-sponsored accounts or if you are self-employed, an IRA is an attractive savings plan option. You must have earned income that meets the IRS definition of income — which interest, dividends, Social Security benefits, and child support do not.

IRAs can be opened through an employer or at banks, investment companies, or brokerages. Established annual maximums limit your contributions. Your funds are distributed into your choice of investments ranging from stocks and bonds to mutual funds and exchange-traded funds (ETFs). The return on your investment is based on the performance of the vehicles you choose.

If you’re under 59½ when you withdraw funds from your IRA, you will pay a 10% penalty on top of any taxes due unless you qualify for an exception. Exceptions include college expenses, a first-time home deposit, unreimbursed medical expenses, and others. Once you reach age 59½, you can withdraw funds from your IRA without incurring an early-withdrawal penalty of 10% of the amount withdrawn. You may, however, pay taxes on original contributions and earnings, depending on the type of IRA you own.

Traditional IRA

If you have earned income and believe your tax bracket will be lower in retirement than now, you may want to open a traditional IRA. You will fund it with pre-tax dollars and take the deduction now while your tax bracket is high.

You are eligible to open a traditional IRA regardless of age as long as you have earned income. The funds can grow tax-deferred until you withdraw either the funds or your earnings — at which time they will be taxed at your current tax rate, plus a 10% penalty on any funds you withdraw before you turn 59½.

Maximum contributions in 2023 are $6,500, with a catch-up amount of $1,000 for individuals 50 or over. You can have both Roth and traditional IRAs, but the annual contribution ceiling applies to both types combined. However, depending on IRS earnings limits, you may be unable to deduct your contributions if you or your spouse has a retirement plan at work.

Pros include your control over your account: you choose your bank or brokerage, and you make all investment decisions. You can leave your funds in your traditional IRA as long as you like, growing tax-deferred, but knowing that you will have to pay taxes upon withdrawal.

Cons include the low maximum contribution ceiling and the income-based phase-out of maximum contributions. Because taxes remain outstanding on traditional IRAs, they are subject to annual required minimum distributions, starting at age 72.

Roth IRA

If you believe your tax bracket is lower now than it will be when you retire, you may consider opening a Roth IRA. It differs from a traditional IRA in that you fund it with after-tax dollars, meaning you will not have to pay taxes upon withdrawal. Roth IRAs, available to anyone with taxable compensation, will appeal to anyone working late in life as you can contribute at any age as long as you have eligible earned income.

Your Roth IRA contributions will grow tax-free in their various investments. When you withdraw your funds in retirement, you will not pay tax on your gains either. You can withdraw contributed funds from your Roth IRA at any age, but not gains.

Maximum contributions in 2023 are $6,500, with a catch-up amount of $1,000 for individuals 50 or over. However, income levels affect possible contributions: in 2023, phase-out occurs between $138,000 and $153,000 for single filers and between $218,000 and $228,000 for married couples filing jointly.

There is no annual required minimum distribution for a Roth IRA starting at age 72. You can leave your funds in your account as long as you like, growing tax-free, knowing your post-retirement funding is available in its entirety. Cons include the low maximum contribution ceiling and the phase-out of contribution maximums based on income.

Spousal IRA (traditional or Roth)

You can open a spousal IRA if you are a non-working spouse whose spouse has eligible earned income. It is identical to a basic IRA in terms of contribution and income limits and can be funded with pre-tax or after-tax funds to create a traditional or Roth IRA, respectively. The one requirement is that you and your spouse must file a joint tax return.

SEP IRA

If you own a small business, are self-employed, or earn income from side jobs, you might have a Simplified Employee Pension (SEP) IRA. A SEP IRA follows the general rules of a traditional IRA. However, only employers or sole proprietors can make contributions directly into an IRA set up for each employee. Also, all qualified employees in the business must receive the same contribution.

Maximum contributions are very generous: up to 25% of each employee’s pay.

SEP IRAs enjoy higher contributions than other IRAs, broad investment choices, and the tax-deferred growth of your account. Unfortunately, SEP IRAs are subject to required minimum distributions when you reach age 72.

Options for small business owners or self-employed

If employed by a small business, you may not have access to a 401(k) plan due to the complexity of setting one up. You also will not have access to one if you are self-employed. However, in addition to traditional and Roth IRAs, a few plans are open to you that meet your specific needs. These include the SEP IRA, the SIMPLE IRA, and the Solo 401(k). The first two have already been described, but the Solo 401(k) is worthy of review.

If you own a business and have no employees other than a spouse — or if you have side gigs in addition to your primary job — the Solo 401(k) can be an invaluable retirement savings tool. However, it will not work if you plan to hire employees. These plans follow the same rules and requirements as other 401(k)s.

Maximum contributions in 2023 are limited to $22,500 as the employee and up to 25% of the employee’s compensation by the employer, capped at a maximum of $66,000 as the employee and employer combined. Being 50 or over adds $7,500 to each figure, and employee contributions cannot exceed 100% of their earned income.

Options for government workers and uniformed services

If you’re a government worker or member of the uniformed services, you have access to the Thrift Savings Plan (TSP). Investment options include funds highlighting bonds, the S&P index, small-cap stocks, international stocks, and specially issued Treasury securities. Several lifecycle funds with their own target retirement dates are also available.

Maximum contributions are $22,500 for 2023, with a catch-up contribution of $7,500 for individuals 50 and over.

Pros to the TSP include a 5% employer contribution to your TSP, made up of a 1% nonelective contribution, a match of the following 3%, and a 50% match of the next 2% you contribute. The investment fees are also extremely low compared with other plans. Cons include the uncertainty experienced with all other defined contribution plans: you don’t know what your balance will be at retirement.

More retirement account options

While the list of retirement savings plan options may seem extensive, there are still many more, such as:

  • Cash value life insurance plans provide a death benefit while building cash value. You can borrow against the cash value to cover retirement needs or leave its entirety to your beneficiaries. These plans are most appealing if you have already reached your contribution limits on 401(k)s and IRAs and are above the average 401(k) balance for your age.

  • Nonqualified deferred compensation (NQDC) plans allow an employee to earn compensation in one year but receive the funds later, deferring taxes to when tax rates may be lower. Because of some of its downsides, contributing to an NQDC plan makes sense if you have maxed out your 401(k) options first, the company is financially secure, and the plan is set up like a 401(k) with employer matching.

  • Cash balance plans resemble defined benefit pension plans with optional lifetime annuities. They do not pay a specific proportion of your income for life. Instead, you are promised a hypothetical account balance defined by established percentages as compensation credits and interest earned.

Need assistance with retirement planning?

No matter how old you are, it’s never too late to start a retirement account that helps fund your later years. FinanceHQ can help by pairing you with a financial advisor who can guide you toward meeting your retirement goals. Our experts can answer questions about choosing the right types of retirement accounts specifically for you, and come up with a good plan to maximize the benefits we’ve discussed.

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Marshall Hargrave
Written byMarshall HargraveContributing writer

Marshall Hargrave is a former SEC-registered investment adviser who is now a strategy consultant for fintech companies.