Not sure which type of retirement plan is the best option? There are a ton of options to choose from, and it can be quite a task to figure out which one is best for you. Let’s face it, the terminology is confusing- it feels like you need an advanced degree just to understand it all!
403(b), 401(k), Roth, TSP, Pre-tax, after tax- it’s a lot to take in. But once you know the basics about retirement plans, it’s not too hard to navigate. Choosing the best retirement plan option for you is one of the most important financial decisions you can make for your future. So, the more you know, the better decisions you can make for your financial future.
You’ll want to make sure you have the best chance of growing your money and minimizing taxes as you enter retirement. Below, I’ll show you the 4 types of retirement plan options available to most people, and help you sort through them all to find which option is best for you.
There are 4 different types of retirement accounts, and several different subtypes available. Here’s a quick list:
- Individual Retirement Accounts (Traditional and Roth IRAs)
- Employer-Sponsored Retirement Accounts (401k, 403b, 457, TSP, Pension)
- Self-Employed and Small BusinessRetirement Accounts
- Taxable Investment Accounts
Below, we’ll get into what each type of account does and help you figure out which one(s) may be best for you.
IRAs (Individual Retirement Accounts)
An Individual Retirement Account is one that allows you to save money for retirement outside of any employer sponsored plan. You can choose from tons of different investment options not available in your workplace plan. This includes stocks, bonds, mutual funds, annuities, and even real estate if you set it up right (more on that below).
The Two Types of IRAs
There are two types of IRAs to choose from:
- Traditional IRA
- Roth IRA
For both types of IRAs, there is a maximum amount you can contribute every year. There are also a few basic rules that apply:
- You can contribute to an account at any age, as long as you have an income
- For 2023 you can contribute up to $6,500 for the year ($7,500 if you are over 50 years old)
- You can start withdrawing money without penalty starting at 59 ½ years old
The rules above apply to all IRAs. However, there are some big differences between Traditional and Roth IRAs. Read on for the details.
With a Traditional IRA, there is no income limit on your contributions. No matter how much you make, you can still put money in. That’s a great perk, especially if you make a high income!
When you contribute to a Traditional IRA, you can claim it as a tax deduction now. Later, when you start withdrawing money in retirement, you will have to pay taxes on those withdrawals.
Although you can start taking money out of your IRA at age 59 ½, you are required to make minimum withdrawals starting at age 72, so you can’t just leave the money there forever.
With a Roth IRA, there are income limits. So, if you make a larger than average income, you may not be able to contribute to a Roth. The great thing about a Roth, though, is that you contribute with after tax dollars. This means you pay taxes on the money you put in now, but as your account multiplies, it grows tax free! Once you start taking money out in your retirement years, you won’t have to pay taxes on the withdrawals.
Also, there are no minimum required distributions at age 72. You can leave money in a Roth IRA as long as you like without any government rules forcing you to take money out.
There are income limits associated with with Roth IRA contributions. For 2023, the income limit for married couples filing jointly is $218,000. For singles, the income limit is $138,000. But if you make too much money, don’t worry, there is still a way you can put money in a Roth IRA.
Backdoor Roth IRA
It’s called a Backdoor Roth IRA. Yeah, it almost sounds a little fishy, but it’s perfectly legal! Here are the 3 steps to make it happen:
- Put money into a Traditional IRA
- Once the money is in your Traditional IRA account, then convert that IRA into a Roth IRA. You may need a professional at your brokerage company to help with that.
- Make sure you are willing to pay the taxes on the money contributed- there is nothing worse than an unexpected tax bill at the end of the year!
Individual Retirement Accounts
|With Traditional IRAs, contributions are tax-deductible and growth is tax-deferred.|
Many more investment options available than with employer sponsored plans.
Roth IRA grows tax-free and withdrawals are tax-free after age 59 1/2.
IRAs are easy to set up.
You are the only contributor- no matches or contributions from your employer.
|Roth IRAs are subject to income limits. High earners don't qualify.|
You can't contribute as much per year as with employer-sponsored retirement accounts.
Penalties apply if you withdraw any funds before age 59 1/2.
Employer Sponsored Retirement Plans
A large percentage of companies provide some type of retirement plan for their workers. Some are better than others. But the best ones give you extra money toward your retirement plan! There are several types of plans available as you’ll see below.
A 401(k) is the most popular type of retirement account offered by employers. In most cases, you will have a limited number of mutual funds to choose from to invest in.
As of 2023, you can put up to $22,500 per year into your 401(k). If you’re age 50 or older, you can put in an additional $7,500 per year, for a total of $30,000 per year. You can choose how much you want to invest automatically out of each paycheck (either a percentage or a set amount).
You can’t withdraw money from your 401(k) before age 59 ½ without penalty. If you do, you’ll have to pay any applicable taxes, plus a hefty early withdrawal penalty, so you should never do it unless you have an extremely good reason.
Most employers will give you an company match up to a certain percentage of your contributions. This is FREE MONEY! So make sure your are at least contributing enough to get that beautiful free match goodness!
Two Types of 401(k)
By the way, there are two types of 401(k) accounts available- Traditional and Roth. The main difference between the two is how the contributions and withdrawals are taxed. Here’s a breakdown:
- Roth 401(k)- Your contributions are taxed in the year you make them (called tax deferred contributions). The money you contribute grows in your account tax-free. So, in retirement, you don’t pay taxes on the gains from your contributions. However, if you get an employer match, you will have to pay taxes on any gains on those contributions your employer made for you.
- Traditional 401(k)- Contributions to a traditional 401(k) are tax deferred, meaning you don’t pay taxes on the money when you contribute. But once you start withdrawing money during retirement, you will have to pay taxes each time you withdraw.
If you work at a tax-exempt organization such as a nonprofit you may be offered a 403(b) plan at work. This includes government employees, teachers, some medical professionals, those in ministry, etc. It’s basically a 401(k) for nonprofit organizations.
A 403(b) works the same way as a 401(k):
- Contribution limits are the same
- Roth and Traditional plans are available
- Early withdrawal penalties are the same
- No-penalty withdrawals begin at age 59 1/2
TSP- Thrift Savings Plan
The Thrift Savings Plan is a retirement plan for federal employees and the military. Just like the 401(k) and 403(b), it has some great tax advantages for retirement. The contributions are automatically deducted from your paycheck, and can be sent to a Traditional or a Roth account.
The main difference is that the TSP has five different investment funds for you to choose from. You can invest in one or a combination of these funds to achieve your retirement investing goals. Here’s a breakdown:
- The Common Stock Index Investment (C) Fund– attempts to match the S&P 500 index
- The Government Securities Investment (G) Fund– invests in short-term U.S. Treasury securities
- International Stock Index Investment (I) Fund– invests in international stocks, attempting to match the performance of the MSCI EAFE (Europe, Australasia, Far East) Index
- The Fixed Income Index Investment (F) Fund– an index fund that tracks the Bloomberg U.S. Aggregate Bond Index, a broadly diversified index of the U.S. bond market
- The Small Capitalization Stock Index (S) Fund– tracks an index of small U.S. company stocks
Company Pension Plans
Company pension plans are becoming less and less common over time. Back in the day, most companies had their own retirement plan for their employees. The company would invest money into a pension fund on your behalf over many years. Once you retire from the company, you get a check every month from the pension fund.
This is known as a defined benefit plan. Once you start getting your monthly check, you’re paid a certain amount based on a formula that takes into account years of service, salary level before retirement, and other factors to determine your specific monthly payout.
Pensions are Less Popular
This is totally different than the typical IRA or 401(k), where you contribute the money yourself. These are known as defined contribution plans, since you are in control of how much you contribute.
Most people currently working won’t be getting a pension when they retire. These days, workers with pensions are mostly union members and government workers including police and teachers. Most private sector companies have done away with pension plans.
The Problem with Pensions
One of the biggest problems with pensions is that you are not in control. If the funds aren’t invested well or are mismanaged, your benefits can drop or even go away completely. Another big problem is that your retirement funds don’t travel with you when you go to a new job. You can’t just roll it into a 401(k) at your new job and be done with it. You are financially tied to that company as long as you have benefits owed to you by the pension fund.
As you can see, pensions are not always the best vehicle for retirement. If you have a pension available, you may be able to cash it out for a lump sum and keep the money in your own investment account. That way, you have complete control over your money and how it’s invested.
Taxable Investment Accounts
A taxable investment account is an individual account that has no contribution or income limits. It’s simply a brokerage account you can open with any broker such as Vanguard or Fidelity, and invest as much as you like into stocks, bonds, mutual funds, ETF’s, and any other investments they offer.
The best thing about taxable investment accounts is freedom. You have the freedom to invest as much as you want, into any investment, any time you want. You’re not restricted by rules on income limits, contribution amounts, or withdrawal age limits.
It’s best to use taxable accounts only after you’ve maxed out your 401(k) and IRA contributions. The one drawback to taxable investment accounts is just that- the earnings are taxable. Each time you sell a stock or mutual fund for a gain, you will have to pay taxes on the gains. So, make sure you set aside a portion for the taxman when you sell.
Small Business and Self-Employed Retirement Accounts
More and more people are working as contractors and are self-employed. Good news! Self employed individuals also have a few good retirement plan options available.
This account is custom made for business owners with no employees. As an individual employed by your business, you can contribute to a Solo 401(k) up to the same limits as any other 401(k). But wait, there’s more! On top of your individual contributions, the business can contribute an additional amount (employer match) up to 25% of your income. Total contributions can be up to $66,000 for 2023.
Once you start hiring employees, the next step is a Simple IRA. You will need to start thinking about helping your employees save for retirement too.
The Simple IRA is a great way for the business owner to contribute to their own retirement, while providing an option for employees to do the same. The employer is typically required to offer a 3% match for employee contributions every year.
As of 2023, employees can save up to $15,500 in the plan (anyone age 50 and older can put in an extra $3,500 as a catch-up contribution).
A different retirement plan option for self employed business owners. A Simplified Employee Pension has the tax advantages of a traditional IRA, but much more money can be contributed every year.
The main difference with a SEP-IRA compared to a Simple IRA is that only the employer is allowed to contribute to the employee’s account. For 2023, an employer can contribute up to 25% of an employee’s pay into their account each year, up to a maximum contribution of $66,000.
Which Retirement Plans are Best for Your Situation?
Every person and how they earn income are different. With that in mind, you’ll first need to find out which account options are available to you.
If you are self-employed, your options will obviously be different than for someone who works in a large corporation. If you’re just not sure, hire a financial planner to help you figure out the best plan for you.
But whether you do it yourself or hire a professional there are a few things you should keep in mind.
1. Invest 15%
Contribute 15% of your gross income into retirement accounts every year.
2. Get the Company Match First
If you have an employer based plan such as a 401(k) and your contributions are matched, you should contribute to that account first up to the maximum match. There’s nothing better than investing with free money!
3. Max Out Your Roth IRA
Once you have received the maximum match from your employer, then you should work on maxing out contributions to your Roth IRA. A Roth allows you to grow your money tax free and have tax free withdrawals when you retire. That’s huge!
However if you earn a high income, you might not be eligible to open or contribute to a Roth IRA. You will have to contribute to a Traditional IRA instead.
4. Contribute More to Your Workplace Retirement Plan
Once you max out your Roth IRA for the tax benefits, then go back and continue to contribute to your workplace plan until you have saved a total of 15% of your gross income for the year throughout all available retirement accounts.
The Best Retirement Plan for You
It takes a little time and research to figure out which retirement accounts work best for you. You won’t be eligible for every type of account, but once you understand what’s available to you, then following the basic concepts above will help you build a nest egg you can be proud of.