Retirement Accounts Explained


January 7, 2022

Retirement Accounts Explained

January 7, 2022

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Conceptual composition. Pension savings. Individual retirement account. Three eggs with the inscriptions IRA, 401k, Roth lie in the nest against the background of the 1040 form. Close-up

Retirement is one of the biggest expenses you’ll have in your life, with one of the longest savings periods of your lifetime, too. Although there are various retirement savings plans available to you, planning for retirement doesn’t have to be overwhelming. U.S. retirement statistics can be a bit depressing; the most recent Survey of Consumer Finances from the Office of Government Accountability measured only 50.6% of American families have retirement accounts as of 2019—yet 79% of employees with access to a workplace retirement plan are using it according to the Employee Benefits Research Institute. Starting now wherever you are is the key to saving in general. Here’s what you need to know about each retirement plan so that you can decide which one (or ones) is best for you.

What Is a Retirement Savings Account, and How Does It Work?

A retirement savings account is a savings vehicle that helps you accumulate money to prepare for retirement and meet your financial goals. Many retirement plan options exist, each with different features, pros, and cons. Depending on your employer, you may have defined benefit or defined contribution plans available to you.

Retirement accounts offer tax-advantaged savings options for investors and pre-retirees. Some plans deduct your contributions before taxes, thus lowering your taxable income. However, you will pay taxes on your contributions and any earnings when you withdraw money from these accounts. Some plans use already taxed income for your contributions, allowing your money to grow tax-free in your retirement account. Retirement accounts offer several advantages over a standard savings account or other brokerage accounts: employer matching on 401(k)s, tax advantages and/or savings, and generally greater growth compared to interest rates on savings accounts.

Let’s get into the different retirement accounts.

Types of Retirement Accounts

We need to distinguish retirement plans offered by employers vs. individual retirement accounts and other plans not offered by employers.

To start the conversation, we must clarify defined benefit plans and defined contribution plans. Defined benefit plans are plans in which employers contribute money to employees’ retirement accounts with or without contributions from employees. Upon retirement, the employee receives a regular payment as long as they meet the eligibility requirements. Pensions are an example of this type of plan, which are becoming far less common among employers.

Defined contribution plans are more common—employees contribute a certain percentage of their paycheck into their retirement account, which the employer may or may not match up to a certain percentage. Examples include 401(k)s and Roth 401(k)s.

Employer-Sponsored Retirement Plans

401(k) Plans

A 401(k) is an employer-sponsored retirement plan. Traditional 401(k)s allow pre-tax contributions, while Roth 401(k) contributions are made with already taxed dollars. Some employers may offer 401(k) matching, where the company matches a set scaled percentage of your contribution (e.g., you contribute 4% of your earnings, and your employer contributes 4%). Additionally, you may have both a traditional 401(k) and a Roth 401(k) available to you—check with your employer for your available options.

Tax Implications: Traditional 401(k) contributions are made with pre-tax dollars, thus lowering your taxable income. The money in your 401(k) account grows tax-free, but you then pay taxes on your withdrawals in retirement. Roth 401(k) contributions are made with after-tax dollars, so you do not have to pay income taxes on withdrawals in retirement. Some employers may allow you to make additional after-tax contributions to your 401(k).

Contribution Limits: The 2021 contribution limit for employees is $19,500; those over aged 50 can contribute an additional $6500. These limits are significantly higher than IRA accounts.

Advantages & Disadvantages: Because you’re making automatic contributions directly from your paycheck (and before it ever hits your bank account), these plans can make the process of saving easier and might take the sting away from reducing your take-home pay. The contribution limit and income tax savings are two other benefits. If your employer matches up to a certain percentage, it’s advisable to take advantage of that additional contribution by contributing the required percentage to maximum employer contribution—free money! Roth 401(k)s do not have an income limit, as Roth IRAs do, meaning you can contribute up to the limit (which is much higher than Roth IRAs). You can generally take a loan from your 401(k) should the need arise.

Some 401(k) plans have account fees that will be paid automatically from your account. Additionally, you generally have limited investment options to choose from with employer-sponsored plans. Early withdrawals before age 59.5 incur penalties (with some exceptions). Also, these accounts can take a number of years to vest, meaning if you separate from your employer, you might not be able to take the employer contributions with you.

Solo 401(k) Plans

This type of 401(k) is for self-employed individuals or business owners with no employees—a true one-person plan.

Tax Implications: Contributions are tax-deductible; the deductions are based on the specific plan.

Contribution Limits: The 2021 contribution limit for employees is $19,500 or 100% of your earned income (whichever is lower); those over age 50 can contribute an additional $6500. You, as the “employer,” can contribute up to 25% of your compensation as the employer contribution. The total annual contribution cannot be greater than $57,000.

Advantages & Disadvantages: You can contribute a significant amount of money to your solo 401(k) with pre-tax dollars. However, if you’re self-employed in a solo business (you cannot have any employees to qualify for a solo 401(k)), you need significant income from your business to fully take advantage of the plan.

Piggy Bank and Wooden Blocks with Number 401k

SIMPLE IRA Plans

SIMPLE stands for Savings Incentive Match Plans for Employees and is another employer-sponsored retirement savings plan for companies with less than 100 employees. Employers must contribute to this plan for their employees, but employees are not required to contribute themselves.

Tax Implications: Much like traditional 401(k)s, employee contributions are made pre-tax, thus lowering your taxable income. The money can grow tax-free. You will pay taxes on your withdrawals in retirement.

Contribution Limits: The 2021 contribution limit is $13,500; those age 50 and over can contribute an additional $3000.

Advantages & Disadvantages: Employers contribute a certain percentage, regardless of if the employee contributes to the plan. The contribution limits are lower than other retirement plan options (e.g., 401(k)s), and the early withdrawal penalty is higher. You cannot take a loan from your SIMPLE IRA plan.

SEP Plans

SEP stands for Simplified Employer Pension. These plans are available for small business owners and self-employed people to make contributions as the employer for themselves (and any applicable employees); only employers are allowed to make contributions.

Tax Implications: Again, like a 401(k), contributions are made pre-tax, reducing your taxable income. Growth is tax-free until you make withdrawals in retirement.

Contribution Limits: Starting in 2022, you can contribute up to $61,000 or 25% of your compensation, whichever is lower.

Advantages & Disadvantages: The contribution limits for SEP plans are higher than IRAs and 401(k)s, and the business owner can deduct contributions from their taxes. However, these can be more complex to set up, so it’s best to consult a financial and tax professional for assistance. Contributions are reliant upon the financial acumen of the business owner and the overall financial success of the business—which can elevate the risk slightly.

Profit-Sharing Plans (PSPs)

PSPs are funded by employer contributions, which share a portion of the business’s profits at their discretion.

Tax Implications: These plans are tax-deferred, meaning taxes are paid on withdrawals in retirement.

Contribution Limits: Contribution limits are set at 25% of an employee’s compensation up to $56,000.

Advantages & Disadvantages: These are often set up in addition to other retirement plans, like a 401(k), and discretionary contributions are made based on the company’s earnings. The key to this plan is that it is discretionary—companies may elect not to contribute, or earnings may dictate no contribution. Early withdrawals also incur penalties.

Defined Benefit Plans

Also called pension plans, these plans are employer-sponsored; employees do not contribute to these plans themselves. They provide employees with a set or “defined” benefit amount in retirement, based on various actuarial factors like salary, age, and employment length with the company. These are becoming less common, as the cost to sponsor and maintain a plan of this type is significantly more expensive than other defined contribution plans. According to Forbes, in a study by Willis Towers Watson, “only 14% of Fortune 500 companies offered defined-benefit plans to new hires in 2019, a decrease from 59% of Fortune 500 companies in 1998.”

Tax Contributions: These follow the tax-deferred process, where taxes are paid on the distributions in retirement.

Contribution Limits: There are no set limits; contributions are defined by actuaries and the employer.

Advantages & Disadvantages: Defined benefit plans offer tax advantages to both the employee and employer; they function much like an annuity, with a guaranteed defined payout upon retirement. They are declining in popularity and are offered much less frequently than they used to be, so it can be difficult to find an employer offering one, and you may not qualify if you don’t work at the company for long enough.

Employee Stock Ownership Plans (ESOPs)

These are defined contribution plans that invest in the sponsoring employer’s stock.

Tax Implications: ESOPs are tax-deferred plans. If and when an employee leaves their employment with the company sponsoring the plan or retires, they receive the fair market value for the stock, which they can either take as a taxable distribution or roll over into an IRA.

Contribution Limits: Allocations are determined by the employer and may be based on the employee’s compensation. The stock is vested according to a specific schedule.

Advantages & Disadvantages: There may be tax benefits for the employee. However, these can be riskier retirement plans, as they are dependent on the company’s performance alone. ESOPs place some percentage of all your retirement funds into one company, in contrast to other retirement plans that allow you to spread out your investments in other companies and securities.

457 Plans

These are retirement plans sponsored by some state and local governmental agency employees and tax-exempt organizations.

Tax Implications: Again, these are tax-deferred accounts, meaning you make pre-tax contributions. Your funds grow tax-free until you take distributions in retirement, upon which you’ll pay taxes. Some plans may allow you to make post-tax or Roth contributions.

Contribution Limits: In 2021, the limit is $19,500; you may be allowed to make catch-up contributions to a degree at a certain age.

Advantages & Disadvantages: Plan funds can be withdrawn with no early withdrawal penalty as soon as the account owner retires, regardless of age. 457 plans may have some employer matching up to a certain limit when combined with individual contribution amounts.

403(b) Plans

These plans are called tax-sheltered annuity plans (TSAs) and are sometimes available for public school employees, church employees, some tax-exempt 501(c)(3) organizations. Both employers and employees can contribute to these plans.

Tax Implications: Contributions are made pre-tax, lowering your taxable income. You will pay taxes on your withdrawals in retirement.

Contribution Limits: For 2022, the contribution limit is $61,000 combined maximum for employer/employee contributions or a proportion of an employee’s salary, whichever is less.

Advantages & Disadvantages: These are tax-deferred plans, meaning your funds can grow tax-free. Many 403(b) plans have shorter vesting periods than 401(k)s. Early withdrawal penalties apply with some exceptions. These plans also typically have fewer investment options than other retirement plans.

Employees Retirement System

The federal government has the Federal Employees Retirement System (FERS), and many states have state-sponsored retirement plans for government employees. The federal plans include the Basic Benefit Plan (an employer-sponsored pension plan), Social Security, and the Thrift Savings Plan (a plan for employee contributions with employer matching, similar to 401(k)s).

Tax Implications: Thrift Savings Plan contributions function like 401(k) plans: tax-deferred growth until withdrawals are made in retirement.

Contribution Limits: The 2021 contribution limit is $19,500, with a $6500 catch-up contribution allowed for those age 50 or more.

Advantages & Disadvantages: Obviously, these are only available to government employees. These plans have employer matches and low fees.

Cash-Balance Plans

These plans are a combination of defined benefit and defined contribution plans and may be offered by employers who previously offered pensions.

Tax Implications: Contributions are made with pre-tax income and follow the general tax-deferred rules, like 401(k)s. These plans are typically reserved for high-income individuals and business owners, thus reducing taxable income.

Contribution Limits: According to SoFi, “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.”

Non-Qualified Deferred Compensation Plans (NQDC)

NQDCs are designed for company executives who have maxed out their contributions to other retirement plans. Compensation and the accompanying taxes are deferred until a later agreed-upon date. These are not limited only to retirement, as the payments can occur at any set date. There are no set limits for these plans.

Health Savings Account (HSA)

An HSA is a way to save for medical expenses in retirement. You can contribute up to $3600 as an individual up to $7200 if you have family coverage. To be eligible, you must have a high-deductible insurance plan (there are risks associated with these types of insurance plans, so make sure you understand all your options before selecting this). You can contribute an additional $1000 if you’re age 55 or older. Your contributions are tax-deductible, and the funds can grow and be withdrawn tax-free if they’re used for eligible health expenses.

Non-Employer-Sponsored Plans

Individual Retirement Accounts (IRAs) – not Roth IRAs

As the individual account owner, you open and fund the IRA yourself, with no employer sponsor or matching. There are no income limits to IRA accounts, meaning you can be a high earner and use a traditional IRA for retirement savings.

Tax Implications: You may be eligible for an income tax deduction on your contributions if you’re not already using an employer-sponsored retirement account and earning less than $74,000. Check your plan to determine if you’re eligible. Your IRA account will grow tax-deferred; when you withdraw funds in retirement, you will pay taxes.

Contribution Limits: The 2021 contribution limit is $6000 and $7000 for those over 50.

Advantages & Disadvantages: You may be able to lower your tax bill come tax time if you are eligible and meet certain requirements. Additionally, you can use an IRA account to roll over 401(k)s from past jobs. There is an early withdrawal penalty if you’re 59.5 or younger. Traditional IRAs usually require withdrawals at age 72 and beyond.

Roth IRA vs Traditional IRA written in the notepad.

Roth IRAs

Like traditional IRAs, you open and fund the IRA yourself as the individual account owner, with no employer sponsor or matching.

Tax Implications: Contributions to Roth IRAs are made with after-tax money, meaning they don’t reduce taxable income or allow for income tax deductions. However, your Roth IRA balance grows tax-free, and your withdrawals in retirement are tax-free also.

Contribution Limits: The 2021 contribution limit is $6000 and $7000 for those over 50.

Advantages & Disadvantages: The single most advantageous aspect of a Roth IRA is the tax-free income in retirement. However, Roth IRAs have income limits; those with a modified AGI of $122,000 or more are not eligible to contribute to these accounts.

Payroll Deduction IRAs

Traditional and Roth IRAs can receive contributions through payroll deductions through their employer. They function the same as the specific plan above but are deducted directly from your paycheck and input into your retirement account. Even though these are deducted through your employer, they cannot contribute to the plan.

Spousal IRAs

These IRAs can help double up retirement savings for couples when one spouse does not work or makes significantly less than the other. Essentially, the non-working spouse opens a traditional or Roth IRA in their name and makes contributions based on the total household income—not their individual income, which is typical of other types of IRAs.

time to decide, wooden letter

Depending on your employer and individual situation, you may have one or several of these plans available to you. It’s important to understand the differences, especially the tax implications, contributions, and pros and cons. The IRS has a comprehensive guide to retirement accounts here. If you’re opening an IRA, you can work with a financial services firm, like a brokerage, bank, or investment adviser. No matter what you choose or have available to you, having a plan to save for retirement is important.


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References

Federal Reserve. (2021, November 4). Survey of Consumer Finances (SCF). https://www.federalreserve.gov/econres/scf/dataviz/scf/table/#series:Retirement_Accounts;demographic:all;population:all;units:have

Greenwald, Lisa, & Fronstin, Paul. (2019, January 10). The State of Employee Benefits: Findings From the 2018 Health and Workplace Benefits Survey. Employee Benefits Research Institute. https://www.ebri.org/docs/default-source/ebri-issue-brief/ebri_ib_470_wbs2-10jan19.pdf?sfvrsn=c5db3e2f_10

Hartman, Rachel. (2021, September 7). Retirement Accounts You Should Consider. U.S. News. https://money.usnews.com/money/retirement/articles/retirement-accounts-you-should-consider

Internal Revenue Service. (2021, August 25.) IRC 403(b) Tax-Sheltered Annuity Plans. https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans

Phipps, Melissa. (2021, November 29). 6 Types of Retirement Plans You Should Know About. The Balance. https://www.thebalance.com/types-of-retirement-plans-2894324

SoFi. (2020, December 23). Understanding the Different Types of Retirement Plans. https://www.sofi.com/learn/content/different-retirement-plan-types/

Tretina, Kat, & Curry, Benjamin. (2021, September 1). Best Retirement Plans for You. Forbes Advisor. https://www.forbes.com/advisor/retirement/best-retirement-plans/