What Are the Types of Retirement Accounts Available to You?
- Retirement savings accounts are specialized investment accounts designed to help individuals reach the long-term goal of funding their retirement.
- There are many different types of retirement savings accounts available, each with its own special benefits and considerations. Of these, 401(k) plans and IRAs are among the most common.
- Before choosing the retirement savings accounts that are best for you, consider your financial status now and craft a concrete plan for the future.
Whether you’re dreaming of a retirement spent traveling the globe, relaxing with family and friends or perfecting your favorite hobby, retirement savings accounts are your primary tool for making those dreams a reality.
Retirement savings accounts are specialized investment vehicles, usually with unique tax benefits, designed to help individuals reach the long-term goal of funding their retirement. Money deposited into a retirement account is invested into various assets — which may include mutual funds, stocks, bonds or other funds depending on the type of account — and set aside to grow until you reach retirement age.
Types of retirement savings accounts
There are many different types of retirement accounts available, each with its own special benefits and considerations. Of these, 401(k) plans and IRAs are among the most common.
What is a 401(k) plan?
401(k) plans are a type of tax-advantaged retirement account sponsored by your employer. A 401(k) allows you, the employee, to contribute a certain dollar amount or percentage of your paycheck to the account. In exchange, your employer will often match these contributions, in full or in part, as an added benefit of your job. Employees can choose from a number of investment options for the money in the account, usually a combination of stock and bond mutual funds and target-date funds.
Depending on the requirements of your plan, employer contributions may be subject to a “vesting” period. This refers to an amount of time, determined by your employer, that you must wait before you have full ownership of the matching funds. Employees are always 100% vested in their own 401(k) contributions, meaning they own those funds outright with no vesting period.
The IRS sets annual contribution limits for 401(k) plans, adjusted for inflation. Once you’ve reached age 59 ½, you can begin making penalty-free withdrawals, and you’re required to make withdrawals after the age of 72. It’s also important to note that there is a 10% penalty for any early withdrawals.
There are two primary types of 401(k) plans: Traditional and Roth. The key difference between them is when and how they are taxed. 401(k) plans — and retirement accounts in general — usually allow you to defer, reduce or eliminate any taxes you’ll pay on the money you invest.
- Traditional 401(k) plans are funded by pre-tax income. This allows you to defer taxes on contributions and the money you earn from interest until you make a withdrawal.
- Roth 401(k) plans, however, rely on after-tax income. As a result, any withdrawals you make during retirement, along with any earnings from interest, remain tax-free.
How do you know which one is better for you? If you anticipate you’ll be in a higher tax bracket when you retire, you might choose a Roth 401(k) so that you’ll save money during retirement by taxing your contributions at a lower rate, not your withdrawals. But if the opposite is true or if you’re currently on a tight budget and need to keep more of your income accessible, you might go for a Traditional 401(k), as your paycheck will take a smaller hit when you contribute pre-tax dollars.
What is an IRA?
An Individual Retirement Account, commonly called an IRA, is also a kind of tax-advantaged account for retirement savings. But unlike 401(k) plans, they are not employer-sponsored. Anyone with earned income can open an IRA, making them a great option for self-employed workers.
With an IRA, you also have more flexibility in how your contributions are invested. You may put money into mutual funds as you would with a 401(k), but you can also select stocks and bonds. As with 401(k) plans, there’s a 10% penalty on withdrawals made before the age of 59 ½.
There are many kinds of IRAs including SIMPLE and SEP, both of which are IRA options designed with small business owners and their employees in mind. However, the most common IRAs for individuals are Traditional and Roth.
- Traditional IRAs are tax-deferred, meaning you don’t pay income tax on the money in the account until it’s withdrawn.
- Roth IRAs, however, are funded by after-tax income. Therefore, the money you withdraw from the account during retirement won’t be taxed.
If you’re trying to choose between the two, think about your tax status now and your likely tax status in the future—will you save more money by paying taxes on your invested income today or during retirement?
How do 401(k) plans and IRAs differ?
A key distinction between 401(k) plans and IRAs is that only 401(k) plans are employer-sponsored. Both types of accounts have limits on yearly contributions, but 401(k) plans usually come with a higher annual limit than IRAs. On the other hand, IRAs usually offer more freedom to choose between different types of investments, while the investment options available with 401(k) plans are more limited.
Both kinds of retirement accounts are great ways to save, but you don’t necessarily have to pick between the two: it’s possible to invest in both an IRA and a 401(k) at the same time.
What are some other types of retirement savings accounts?
Although 401(k) plans and IRAs are among the most common, they are far from the only options available. Other types of retirement savings accounts include:
403(b) and 457(b) plans. Similar to 401(k) plans, 403(b) and 457(b) plans are employer-sponsored retirement savings accounts that are funded by contributions from your paycheck and may be matched by your employer. However, these plans are only offered to employees of public schools and colleges, non-profits, churches and municipal, state and federal governments. As with 401(k) plans, Traditional and Roth versions of these accounts are available.
Employee Stock Ownership Plans (ESOPs). An ESOP is a kind of profit-sharing retirement benefit that gives employees access to shares of their employer’s stock. The company uses a trust fund to buy stock, which it then allocates to individual employees.
If your employer offers an ESOP, you’ll have access to the stock when you leave the company or retire, and the employer is required to buy back the stock you own at a fair market price. There are limits to how and when you can receive distributions from your ESOP without a penalty. Normally, you must be over retirement age. Much like other types of retirement accounts, ESOPs are tax-advantaged for both the employer and the employee. However, unlike an IRA or 401(k), you don’t pay anything into the account — your employer makes contributions and you benefit.
SIMPLE and SEP IRAs. SIMPLE and SEP IRAs are retirement options geared toward sole proprietors and other small businesses:
- SIMPLE stands for Savings Incentive Match Plan for Employees. This type of IRA is available to businesses with 1,000 employees or less and annual revenues of at least $5,000. SIMPLE IRAs allow employees to have retirement contributions deducted from their paycheck and deposited into a tax-deferred savings account. Employees can also contribute up to a certain amount directly to these accounts each year. Employers are required to match a certain amount of employee contributions similar to how they might for a 401(k).
SIMPLE IRAs work much like traditional IRAs in that money is taxed only when it’s withdrawn. Account holders may also face a penalty for withdrawing funds before the age of 59 ½.
- SEP stands for Simplified Employee Pension. This type of IRA allows employers to set money aside in retirement accounts that they and their employees can draw on in retirement. Employers can contribute a certain amount of the employee’s pay into a tax-deferred SEP IRA, but the employee cannot make any additional contributions. However, employees are always 100% vested in their SEP IRA funds. Similar to a Traditional IRA, SEP funds are taxed only as money is withdrawn, and there may be fees for withdrawals before the age of 59 ½.
What do I need to know before opening a retirement account?
Before choosing the retirement savings accounts that are best for you, consider your financial status now, and craft a concrete plan for the future. When will you retire? How much do you need to save to maintain your desired standard of living? What will your Social Security benefits look like? What will you do in case of an emergency? Are you likely to move into a higher or lower tax bracket later in life?
No matter how you answer these questions, the most important thing to remember is also the simplest: start saving as soon as possible. The power of compounding interest means that the sooner you start saving, the more time your money has to grow. Whether you invest in an IRA, a 401(k), an ESOP or another type of retirement savings plan, your happily retired future self will thank you.
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