Learning how to plan for retirement doesn't have to feel overwhelming. The various retirement plans available are easier to understand than you might think, although each is subject to its own limitations. Some of these limitations depend on your modified adjusted gross income, while others involve a cap on the amount of money you can contribute yearly.
Tax treatment of withdrawals—and the age at which you can and must take withdrawals without penalty—can vary among types of plans as well. A comparison can help you identify which is best for you.
A 401(k) plan is a workplace retirement account that's offered as an employee savings plan benefit. This account allows you to contribute a portion of your pre-tax paycheck to tax-deferred investments. That reduces the amount of income you must pay taxes on that year. For example, if you were to earn $75,000 and contribute $5,000 to your 401(k), you'd only be taxed on $70,000.
Investment gains grow tax-deferred until you withdraw the money in retirement. If you withdraw funds from the plan before age 59 1/2, however, you could pay a 10% penalty, and the withdrawal would be subject to federal and state income taxes. Some plans allow 401(k) loans, however, if you find yourself in a cash emergency.
Some employers match their employees' contributions to a 401(k), typically up to 6%. However, you might not be fully "vested" in your plan for a number of years. That means you wouldn't be able to take your employer's contributions with you if you were to leave the company before the prescribed period of time had elapsed. Your own contributions to the plan are always yours, however.
If you're not contributing up to the company match, you could be ignoring a significant employee benefit. That match is effectively free money. Employers who offer these plans are often willing to let you make contributions through automatic payroll deductions, which can make saving easier.
Investment choices for these types of plans are often limited, and management and administrative fees can be high. The IRS imposes contribution limits per year, although limits for 401(k) plans are more generous than those for other plans: $20,500 in 2022 (up from $19,500 in 2021). This increases to $26,000 if you're 50 or older and take advantage of the allowed $6,500 catch-up contribution.
An IRA is a tax-favored investment account. You can use the account to invest in stocks, bonds, mutual funds, ETFs, and other types of investments after you place money into it, and you make the investment decisions yourself unless you want to hire someone else to do so for you. You might consider investing in a traditional IRA if your employer doesn't offer a retirement plan or if you've maxed out your 401(k) contributions for the year.
You can contribute up to $6,000 in 2022. This increases to $7,000 if you're age 50 or older. This limit is unchanged from 2021 limits. You'll pay no taxes annually on investment gains, which helps them to grow more quickly.
Many taxpayers can deduct their IRA contributions on their income tax returns if they don't also have a 401(k) retirement account, which reduces their taxable income for that year. Some restrictions exist based on income. You pay income taxes on the money you contributed and on gains when the money is withdrawn in retirement.
You can buy and sell investments within the IRA, but if you try to take money out before you reach age 59 1/2, that is known as an "early distribution," and you'll probably have to pay a 10% penalty fee, just as you would with a 401(k). You'll also be subject to federal and state and income taxes on the withdrawal.
Unlike a traditional IRA, Roth IRA contributions are made with after-tax dollars, but any money generated within the Roth is never taxed again.
You can withdraw contributions you've made to a Roth IRA before retirement age without penalty, provided five years have passed since your first contribution. You're not currently required to begin taking withdrawals at age 72, as you are with traditional IRAs, 401(k)s, and other retirement savings plans.
Putting money in a Roth is a great place to invest extra cash if you're just starting out, and you think your income will grow. You can even contribute to both an IRA and a Roth IRA, but your total contributions to both plans can't exceed the $6,000 contribution limit for the year or $7,000 if you're age 50 or older.
A Roth 401(k) combines features of the Roth IRA and a 401(k). It's a type of account offered through employers, introduced in 2006. As with a Roth IRA, contributions come from your after-tax paycheck rather than your pre-tax salary. Contributions and earnings in a Roth are never taxed again if you remain in the plan for at least five years.
The best part about a Roth 401(k) is that there is no income limit as with a Roth IRA. The annual contributions are the same as a traditional 401(k), too—just with after-tax dollars. Withdrawals are the same as with a Roth IRA as well, but the distribution rules match those of a traditional 401(k).
The Savings Incentive Match for Employees (SIMPLE) IRA is a retirement plan that small businesses with up to 100 employees can offer. It works very much like a 401(k).
Contributions are made with pre-tax paycheck withdrawals, and the money grows tax-deferred until retirement.
Early distributions can result in a hefty penalty, however. Unless you qualify for an exception, you’ll have to pay an additional 10% tax on the amount you withdraw from your SIMPLE IRA (similar to Traditional IRAs and 401(k) plans). If you make the withdrawal within two years from when you first participated in the SIMPLE IRA plan, this additional tax increases to 25%. You can't borrow from a SIMPLE IRA, either, the way you can from a 401(k).
A Simplified Employee Pension (SEP) IRA allows you to contribute a portion of your income to your own retirement account if you're self-employed and have no employees. You can fully deduct these contributions from your taxable income.
The maximum annual contribution limits are higher than most other tax-favored retirement accounts: $61,000 for 2022 (up from $58,000 in 2021), or 25% of income— whichever is less.