6 Types of Retirement Plans You Should Know About
Each Type Comes With Its Own Restrictions and Benefits
Learning how to plan for retirement doesn't have to feel like mastering another language. 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 take and must take withdrawals without penalty—can vary between 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 benefit. The account allows you to contribute a portion of your pre-tax paycheck to tax-deferred investments. This reduces the amount of income you must pay taxes on in that year. For example, you'd be taxed on $70,000 if you earned $75,000 and contributed $5,000 to your 401(k).
Investment gains grow tax deferred until you withdraw the money in retirement. If you withdraw funds from the plan before age 59½, however, you could pay a 10% penalty, and the withdrawal would be subject to federal and state income taxes. Some plans offer 401(k) loans, however, if you find yourself in a cash emergency.
Although it's becoming more rare, some employers match employee contributions to a 401(k), typically up to 6%, although it might "vest" its contributions over a period of years. This means you wouldn't be able to take your employer's contributions with you if you leave the company before the prescribed period of time has 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. An employer 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: $19,500 in 2020, up from $19,000 in 2019. This increases to $26,000 if you're 50 or older.
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 an IRA if your employer doesn't offer a retirement plan or if you've maxed out your 401(k) contributions for the year.
You contribute up to $6,000 in 2020. This increases to $7,000 if you're age 50 or older. This limit is the same as in 2019. 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 59½, this 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 take 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 required to begin taking withdrawals at age 70½ as you are with traditional IRAs, 401(k)s, and other retirements 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.
A Roth 401(k) combines features of the Roth IRA and a 401(k). It's a type of account offered through employers, and it's relatively new. 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 Roth IRAs, too, 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 pretax paycheck withdrawals, and the money grows tax deferred until retirement.
Distributions taken within two years of opening the plan and before age 59½ can result in a hefty penalty, however—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: $57,000 or 25% of income— whichever is less—as of 2020.