Retirement will likely be the biggest expense of your lifetime, which means saving for retirement is a big job. This is especially true if you envision a retirement that is rich with experiences such as traveling through Europe, spending time with your grown children and grandkids, or turning your home into a Wild Kingdom of rescue animals. A retirement savings plan can help you accomplish your goals and stay on track.
What Is A Retirement Savings Plan?
A retirement savings plan is a strategy for accumulating the money needed to meet one’s retirement goals. It may entail different account types (pension, IRA, 401(k), etc.) and guidelines for budgeting and spending.
Saving and investing for retirement isn’t always so straightforward, beginning with the question of where to save and invest: There are many different types of retirement plans, and it can be confusing to know which is right for you.
Let’s get into the specifics for different types of retirement accounts.
How Do Retirement Accounts Work?
Retirement accounts like 401(k)s and IRAs provide investors with a tax-advantaged way to save for retirement. Investors with traditional plans pay taxes on their contributions and earnings upon withdrawal. Those with Roth plans pay taxes on contributions up-front and their money is able to grow tax-free.
Retirement accounts often have tax advantages as compared to saving within a “regular” savings account or investing with a brokerage account. There can be other benefits to using a retirement account—such as an employer match in a 401(k)—but really, it’s the tax benefits that make them unique.
A discussion of the different types of retirement plans requires an understanding of that taxation, along with who establishes and uses each account, the rules of the plan, and ultimately, which type is best for you.
Different Types of Retirement Accounts
There are several different types of retirement accounts, including some traditional plan types you may be familiar with as well as non-traditional options.
What Is A Traditional Retirement Plan?
Traditional retirement plans can be individual retirement accounts (IRAs) or 401(k)s. Traditional retirement plans allow you to contribute pre-tax dollars to an account. With a traditional IRA or 401(k), you only pay taxes on your investments when you withdraw from the account.
Non-traditional retirement plans can include Roth 401(ks) and IRAs, for which you pay taxes on funds before contributing them to the account.
Let’s take a closer look at some of the most common retirement plan types.
Traditional Individual Retirement Accounts (IRAs)
Individual retirement accounts (IRAs) are managed by the individual policyholder.
With an IRA, you open and fund the IRA yourself. This is not a plan you join through an employer.
Income Taxes: You may receive an income tax deduction on contributions (depending on your income and access to another retirement plan through work). The balance in the IRA will always grow tax-deferred, and withdrawals will be taxed (the amount will vary depending on whether contributions were deductible or non-deductible).
Contribution Limit: $6,000 in 2020 and 2021 $7,000 for people age 50 or over.
Pros: You might be able to lower your tax bill if you’re eligible to make deductible contributions. Additionally, the money will grow tax-deferred, which can make a difference over a long period of time. Finally, there are no income limits for contributing to a traditional IRA.
Usually best for: People who can make deductible contributions and want to lower their tax bill, or individuals who earn too much money to contribute directly to a Roth IRA. Higher-income earners might not get to deduct contributions from their taxes now, but they can take advantage of tax-deferred growth between now and retirement. An IRA can also be used for consolidating and rolling over 401(k) accounts from previous jobs.
To consider: There is a 10% penalty for withdrawing funds before age 59½. You cannot deduct IRA contributions if you’re already covered by a retirement account through your work and earn more (according to your modified gross adjusted income) than $74,000 (with a phase-out beginning at $64,000).
Cons: Traditional IRAs come with a number of restrictions, including how much can be contributed and when you can start withdrawals without penalty. Traditional IRAs are also essentially a bet on the tax rate you will be paying when you begin withdrawals after age 59½, as the accounts grow tax-deferred but are taxed upon withdrawal. Also, traditional IRAs generally mandate withdrawals starting at age 72.
Income Taxes: Roth IRA contributions are made with after-tax money, which means you won’t receive an income tax deduction for contributions. But your balance will grow tax-free and you’ll be able to withdraw the money tax-free in retirement.
Contribution Limit: $6,000 in 2020 and 2021 $7,000 for people age 50 or over.
Pros: While contributing to a Roth IRA won’t lower your tax bill now, having the money grow tax-free and being able to withdraw the money tax-free down the road provides value in the future.
Usually best for: Someone who wants to take advantage of the flexibility to withdraw from an account during retirement without paying taxes. Additionally, it can be especially beneficial for people who are currently in a low income-tax bracket and expect to be in a higher income tax bracket in the future.
To consider: To contribute to a Roth IRA, you must have an earned income. Your ability to contribute begins to phase out when your income (specifically, your modified adjusted gross income) reaches $122,000. As a joint filer, your ability to contribute to a Roth IRA phases out at $193,000.
Cons: Like a traditional IRA, a Roth IRA has tight contribution restrictions. Unlike a traditional IRA, it does not offer tax deductions for contributions. As with a traditional IRA, there’s a penalty for taking some kinds of distributions before age 59 ½.
A 401(k) plan is a type of work retirement plan offered to the employees of a company. Traditional 401(k)s allow employees to contribute pre-tax dollars, where Roth 401(k)s allow after-tax contributions.
Income Taxes: If you choose to make a pre-tax contribution, your contributions will reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement. Additionally, some employers allow you to make after-tax or Roth contributions to a 401(k). You should check with your employer to see if those are options.
Contribution Limit: $19,500 in 2020 and 2021 for the employee; people over the age of 50 can contribute an additional $6,500.
Pros: Money is deducted from your paycheck, automating the process of saving. Some companies offer a company match. There is a significantly higher limit than with Traditional IRA and Roth IRA accounts.
Usually best for: Someone who works for a company that offers one, especially if the employer provides a matching contribution. A 401(k) retirement plan can also be especially useful for people who want to put retirement savings on autopilot.
To consider: Sometimes, 401(k) plans have account maintenance or other fees. Because a 401(k) plan is set up by your employer, investors only get to choose from the investment options they provide.
Cons: With a 401(k) plan, you are largely at the mercy of your employer—there’s no guarantee they will pick plans that you feel are right for you or are cost effective for what they offer. Also the value of a 401(k) comes from two things: the pre-tax contributions and the employer match, if your employer doesn’t match, a 401(k) may not be as valuable to an investor. There are also penalties for early withdrawals before age 59 ½, although there are some exceptions, including for certain public employees.
Solo 401(k) Plans
This is essentially a 1-person 401(k) plan for self-employed individuals or business owners with no employees, in which you are the employer and the employee.
Income Taxes: The contributions made to the plan are tax-deductible.
Contribution Limit: $19,500 in 2020 and 2021, or 100% of your earned income, whichever is lower, plus “employer” contributions of up to 25% of your compensation from the business. The total cannot exceed $57,000. (On top of that, people over age 50 are allowed to contribute an additional $6,500.)
Pros: A solo 401(k) retirement plan allows for large amounts of money to be invested with pre-tax dollars. It provides some of the benefits of a traditional 401(k) for those who don’t have access to a traditional employer-sponsored 401(k) retirement account.
Usually best for: Self- employed people with enough income and a large enough business to fully use the plan.
Cons: You can’t open a solo 401(k) if you have any employees (though you can hire your spouse so they can also contribute to the plan as an employee—and you can match their contributions as the employer).
SIMPLE IRA Plans (Savings Incentive Match Plans for Employees)
This retirement plan is set up by an employer, who is required to contribute on employees’ behalf, although employees are not required to contribute.
Income Taxes: Employee contributions are made with pre-tax dollars. Additionally, the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement.
Contribution Limit: $13,500 in 2020 and 2021 ; $16,500 for employees age 50 and over.
Pros: Employers contribute to eligible employees’ retirement accounts at 2% their salaries, whether or not the employees do themselves. (Aka: free money.) For employees who do contribute, the company will match up to 3%.
To consider: Only employers with less than 100 employees are allowed to participate.
Cons: The contribution limits for employees are lower than in a 401(k) and the penalties for early withdrawals—25%— before age 59½ are higher.
SEP Plans (Simplified Employee Pension)
This is a retirement account established by a small business owner or self-employed person for themselves (and if applicable, any employees).
Income Taxes: Your contributions will reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on withdrawals in retirement.
Contribution Limit: For 2020, whichever is lower: $57,000 or 25% of earned income.
Pros: Higher contribution limit than IRA and Roth IRAs, and contributions are tax deductible for the business owner.
Usually best for: Self-employed people and small business owners who wish to contribute to an IRA for themselves and/or their employees.
To consider: Because you’re setting up a retirement plan for a business, there’s more paperwork and unique rules. When opening an employer-sponsored retirement plan, it helps to consult a tax advisor.
Cons: These plans are employer contribution only and greatly rely on the financial wherewithal and available cash of the business itself.
Payroll Deduction IRAs
Either a traditional or Roth IRA that is funded through payroll deductions.
Income Taxes: For a Traditional IRA, you may receive an income tax deduction on contributions (depending on income and access to a retirement plan through work); the balance in the IRA will always grow tax-deferred, and withdrawals will be taxed (how much is taxed depends on if you made deductible or non-deductible contributions). For a Roth IRA, contributions are made with after-tax money, your balance will grow tax-free and you’ll be able to withdraw the money tax-free in retirement.
Contribution Limit: $6,000 or $7,000 for people age 50 or over.
Pros: Automatically deposits money from your paycheck into a retirement account.
Usually best for: People who do not have access to another retirement plan through their employer.
To consider: These have the same rules as a Traditional IRA, such as a 10% penalty for withdrawing funds before age 59½. Only employees can contribute to a Payroll Deduction IRA.
Cons: The employee must do the work of setting up a plan, and employers can not contribute to it as with a 401(k). Participants can not borrow against the retirement plan or use it as collateral for loans.
Profit-Sharing Plans (PSPs)
A retirement plan funded by discretionary employer contributions that gives employees a share in the profits of a company.
Income taxes: Deferred; assessed on distributions from the account in retirement.
Contribution Limit: The lesser of 25% of the employee’s compensation or $56,000.
Pros: An employee receives a percentage of a company’s profits based on its earnings. Companies can set these up in addition to other qualified retirement plans, and make contributions on a completely voluntary basis.
Usually best for: Companies who want the flexibility to contribute to a PSP on an ad hoc basis.
To consider: Early withdrawal from the plan is subject to penalty.
Cons: These plans put employees at the mercy of their employers’ profits, unlike retirement plans that allow employees to invest in securities issued by other companies.
Defined Benefit Plans
These plans, more commonly known as pension plans, are retirement plans provided by the employer where an employee’s retirement benefits are calculated using a formula that factors in age, salary, and length of employment.
Income taxes: Deferred; assessed on distributions from the plan in retirement.
Contribution limit: Determined by an enrolled actuary and the employer.
Pros: Provides tax benefits to both the employer and employee and provides a fixed payout upon retirement that many retirees find desirable.
Usually best for: Companies that want to provide their employees with a “defined” or pre-determined benefit in their retirement years.
To consider: These plans are becoming less popular because they cost an employer significantly more in upkeep than a defined contribution plan such as a 401(k) program.
Cons: These plans are increasingly rare, but for those who do have them, issues can include difficulty realizing or accessing benefits if you don’t work at a company for long enough.
Employee Stock Ownership Plans (ESOPs)
A qualified defined contribution plan that invests in the stock of the sponsoring employer.
Income taxes: Deferred. When an employee leaves a company or retires, they receive the fair market value for the stock they own. They can either take a taxable distribution or roll the money into an IRA.
Contribution limits: Allocations are made by the employer, usually on the basis of relative pay. There is typically a vesting schedule where employees gain access to shares in one to six years.
Pros: Could provide tax advantages to the employee. ESOP plans also align the interests of a company and its employees.
Cons: These plans concentrate risk for employees: An employee already risks losing their job if an employer is doing poorly financially, by making some of their compensation employee stock, that risk is magnified. In contrast, other retirement plans allow an employee to invest in stocks in other securities that are not tied to the financial performance of their employer.
An employer-sponsored deferred compensation plan for employees of state and local government agencies and some tax-exempt organizations.
Income taxes: If you choose to make a pre-tax contribution, your contributions will reduce your taxable income. Additionally, the money will grow tax-deferred and you will pay taxes on the withdrawals in retirement. Additionally, some employers also allow you to make after-tax or Roth contributions to a 401k.
Contribution limits: $19,500 in 2020 and 2021 ; some plans allow for “catch-up” contributions.
Pros: Plan participants can withdraw as soon they are retired at any age, they do not have to wait until age 59½ as with 401(k) and 403(b) plans.
Usually best for: Employees of governmental agencies.
Cons: 457 plans do not have the same kind of employer match as a 401(k) plan. While employers can contribute to the plan, it’s only up to the combined limit for individual contributions.
Guaranteed Income Annuities (GIAs)
These are products sold by insurance companies. They are similar to the increasingly-rare defined benefit pensions in that they have a fixed payout that will last until the end of life. These products are generally available to people who are already eligible to receive payouts from their retirement plans.
Income Taxes: If the annuity is funded by 401(k) benefits, then it is taxed like income. Annuities purchased with Roth IRAs, however, have a different tax structure. For “non-qualified annuities,” i.e. annuities purchased with after-tax income, a formula is used to determine the taxes so that the earnings and principal can be separated out.
Contribution Limit: Annuities do not have contribution limits.
Pros: These allow for payouts until the end of life and are fixed, meaning they’re not dependent on market performance.
Usually best for: People who have high levels of savings and can afford to make expensive initial payments on annuities.
Federal Government Plan
The federal government operates its own retirement plan for federal employees, known as the Federal Employees Retirement System. It includes three parts: the Basic Benefit Plan, Social Security, and the Thrift Savings Plan. The Basic Benefit Plan is an employer-provided pension plan, while the Thrift Savings Plan is most analogous to what private sector employees can receive.
Income Taxes: Contributions to the Thrift Savings Plan are made before taxes and grow tax-free until withdrawal in retirement.
Contribution Limit: The contribution limit for employees is $19,500, with $6,500 “catch-up” contributions for those over 50 and a combined $58,000 limit for all contributions, including from the employer agency.
Pros: This plan is renowned for its low administrative fees and employer matches.
Usually best for: Federal government employees who will work at their agencies for a long period; it is comparable to 401(k) plans in the private sector.
This is another type of pension plan that combines features of defined benefit and defined contribution plans. They are sometimes offered by employers that previously had defined benefit plans. The plans provide an employee an “employer contribution equal to a percent of each year’s earnings and a rate of return on that contribution.”
Income Taxes: Contributions come out of pre-tax income, similar to 401(k).
Contribution Limit: The plans combine a “pay credit” based on an employee’s salary and an “interest credit” that’s a certain percentage rate; the employee then gets an account balance worth of benefits upon retirement that can be paid out as an annuity (payments for life) or a lump sum. Limits depend on age, but for those over 60, they can be more than $250,000.
Pros: Can reduce taxable income.
Usually best for: High earners, business owners with consistent income.
Cash-Value Life Insurance Plan
Cash-value life insurance covers the policyholder’s entire life and has tax-deferred savings, making it comparable to other retirement plans. Some of the premium paid every month goes to this investment product, which grows over time.
Income Taxes: Taxes are deferred until the policy is withdrawn from, at which point withdrawals are taxed at the policyholder’s current income tax rate.
Contribution Limit: The plan is drawn up with an insurance company with set premiums.
Pros: These plans have a tax-deferring feature and can be borrowed from.
Usually best for: High earners who have maxed out other retirement plans.
Nonqualified Deferred Compensation Plans (NQDC)
These are plans typically designed for executives at companies who have maxed out other retirement plans. These plans defer payments—and the taxes—you would otherwise receive as salary to a later date.
Income Taxes: Income taxes are deferred until you receive the payments at the agreed-upon date.
Contribution Limit: None
Pros: The plans don’t have to be entirely geared around retirement. While you can set dates with some flexibility, they are fixed.
Usually best for: Highly-paid employees for whom typical retirement plans would not provide enough savings compared to their income.
Depending on your employment circumstances, there are many possible retirement plans in which you can invest money for retirement. Some are offered by employers, others can be set up by an individual.
Likewise, the benefits for each of the available retirement plans differ, though they all share one positive attribute: Investing in them is an important step in saving for retirement.
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