Retirement Savings: Which Retirement Plan is Right for You?
Published on December 29, 2017
By John Foley CFP®
If you’re like most people, you might be a bit overwhelmed by all the different types of retirement savings plans out there.
And that’s fair: The choices are confusing for two reasons. First, each of the common retirement plans was created by a separate law, and each has its own set of rules that are similar, but not the same. Second, the names are weird. Some of them are named after the person who proposed them—like Senator William Roth of Delaware. Others, like the 401(k) and 403(b), are named after sections of the IRS code. Best of all, none of these names contain any useful information for people who are trying to choose among them.
But don’t let that stop you from doing your research and choosing the plan that’s right for you. After all, they’re all designed to give you tax breaks to help you save and invest for retirement. Here, we’ll break them down, as well as offer some guidance on how you might use them.
401(k)s and Similar Employer-Sponsored Plans
If your employer offers one, the best place to start investing for retirement is with an employer-sponsored plan. The law determines what kind of employer can offer which kind of plan. In the private sector, this is usually a 401(k); the 403(b) and 457(b) are similar plans in the government, academic, and nonprofit worlds.
What every employer’s plan has in common is:
-Your employer chooses the plan.
-You decide how much money to contribute.
-Contributions are deducted from your paycheck.
-You decide how to invest your contributions among the investment choices your plan offers (usually, different types of mutual funds).
-Your money can’t be withdrawn without penalty until you retire (or if you die or become disabled).
-If you leave the job, you may “rollover” your balance to another employer’s plan or individual retirement arrangement (IRA) without paying any taxes or penalties.
From there, though, the rules vary based on the specific plan type and the choices your employer makes. For example, your employer may (or may not) match some portion of your contribution or make contributions from other sources, such as profit sharing. Employer contributions may vest over a period of years and you can lose them if you quit before you’re fully vested. Contribution limits vary by the type of plan and your age. (For example, the maximum you can put in your 401(k) in 2017 is $18,000 per year. If you are over age 50, you can save an additional $6,000 in “catch-up” contributions.)
The age of retirement can vary by the type of plan, as do the rules if you need to take out money beforehand. Some plans allow you to withdraw money to fund education or a first home, and some permit you to borrow money for any reason. In short, it all depends, and your HR department is the best source for specific rules for your plan.
How much should you contribute to your 401(k)? If your employer matches contributions, be sure you contribute at least enough to get the full matching funds. It’s free money! Beyond that, it depends on your circumstances. In general, you should start saving for retirement as early as you can, and save as much as you can, increasing your contributions every time you get a raise or a bonus.
Of course, not everyone is employed by a company that offers a retirement plan, which is where Individual Retirement Arrangements (IRAs) come in. Initially, they were intended for people who had no company pension plan, but they are available to many people who do.
IRAs come in two forms—Traditional or Roth—and the difference is tax treatment.
With a Roth IRA, your contributions are are not tax-deductible, but your distributions in retirement are tax-free. With a traditional IRA, money you contribute is not taxed, but your withdrawals in retirement are taxed as ordinary income. Which should you choose? If you are not paying a high tax rate now, it might be smart to opt for a Roth, since you could be in a higher tax bracket when you retire. But if you need a deduction to motivate you to save—go with a Traditional IRA.
In Traditional IRAs there’s a 10% penalty if take your money out before age 59½, and you must start taking distributions at 70½. In Roth accounts, the early distribution penalty only applies to earnings, not contributions and you don’t need to start withdrawals at any time. In both cases, you pay no tax on dividends, interest, or capital gains that accumulate while assets are in the account. So your retirement nest egg isn’t being taxed every year.
Contributions rules are complicated. Broadly, you can contribute $5,500 each year (or $6,500 if you are 50 or older). However, there are limits that depend on your age, income, marital status, and whether you have an employer sponsored plan. To know how much you can contribute, try our IRA calculator.
Most investment firms offer IRAs and let you invest in most things they offer (such as stocks, bonds, and mutual funds). If you want to make your own investment decisions, or don’t like the investments in your company’s plan, you might want an IRA instead, even though the contribution limits are usually lower. Depending on your income, you may be able to contribute to both an employer plan and an IRA.
Types of Self Employed Retirement Plans
If you’re self-employed or a contractor, you also have access to another set of retirement plans. The good news: Contribution limits are higher than an IRA or a 401(k), since you are both the employer and the employee.
There are two choices:
SEP IRA – This is basically a Traditional IRA account with much higher contribution limits—up to $54,000 in 2017. Your contribution is based on your net earnings. That’s net of your Social Security contribution, so the calculation is complicated, but the IRA calculator can estimate it for you. (Read more about the SEP IRA.)
Solo 401(k) – This is a 401(k) with simplified reporting requirements, since it only has one participant—you. You can make an $18,000 employee contribution plus an employer contribution equal to the amount you could contribute to a SEP IRA with the same net earnings. The maximum contribution is still $54,000 though.
Which is better—a SEP IRA or a Solo 401(k)? It depends on how much you can afford to contribute. If you’ll make over $281,110 in 2017 or won’t be able to contribute more than 18.6% of your income anyway (because you need to buy food, shelter, and clothing) go with a SEP IRA. However, if you make less than $281,110 and want to maximize your contribution, a Solo 401(k) might be better. It’s perfect for a side gig if you have your expenses covered by another income source. For example, if you make $25,000 at a side gig and want to contribute as much of that as you can, you could make a $2,616 employer contribution plus an $18,000 employee contribution to the Solo 401(k). Your SEP contribution, however, would be only $4,646.
Old-School Pension Plans
If you work for the military, the government, and some large companies, you might have a pension plan. These are becoming much less common as more employers turn retirement responsibility over to their employees, but they’re still out there, so they’re worth a mention. There are two broad types of pension plans:
Defined Benefit Pension – These plans pay you an income for life when you retire. The amount you get is usually determined by a formula based on your income and years of service. For example: the average of your final 5 years of salary times 3% for each year of service, up to a max of 80%. So if you worked for 20 years, and averaged $100,000 in your last 5 years, you’d get $60,000. There are often several payout options, so be sure you understand them before you’re ready to retire.
Defined Contribution Pension – This pension plan defines the amount the company will contribute—usually a fixed percentage of your salary each year. Your money in this plan will generally vest over time. If you leave in the first few years you probably lose all or most of it. The longer you stay, the more of it you own and can take with you when you leave. Some plans invest it for you, but most let you choose how your money is invested.
Participation in both of these is automatic. You don’t generally need to contribute to these plans, but it’s important to understand their value if you have one. If you are in the military or work for the government or a firm that has one of these, they are an important part of your compensation.
If you have a pension plan or your employer makes profit sharing contributions to a contributory plan, be sure you understand the vesting schedule before you decide to change jobs. You don’t want to quit the week before you start to vest.
Rollover Your 401(k) to an IRA
Of course, most people will change jobs several times in their career. After a few job changes you can find yourself losing track of old plans with former employers. It may be smart to consolidate your retirement accounts by rolling them over into an IRA to make it easier to manage your money. You generally can’t rollover a plan from your current employer, but you can with past ones.
Have questions about retirement? Use our retirement calculator or consider working with a SoFi Wealth advisor today. We can help you pick investments in your current plan, rollover old plans with former employers, and get your retirement plan on track.SoFi Wealth, LLC does not render tax or legal advice. Individual circumstances are unique and we recommend that you consult with a qualified tax advisor for your specific needs.
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