Employee pension plans are a rarity, and relying on social security may not cover living costs by retirement age. Understanding what retirement plans are available and their benefits are essential to prepare yourself for a comfortable retirement. Each retirement plan differs in how much you can contribute annually, how it’s taxed, how withdrawals work, what you can invest in, and how much you pay in fees. We will review employer-sponsored plans, individual retirement accounts, and plans for self-employed individuals and small business owners.
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These employer-sponsored retirement accounts allow you to contribute a portion of your paycheck or self-employment income and choose various savings and investment options such as CDs, stock funds, bond funds, and money market funds to accelerate your account growth. Employee contributions to a 401(k) plan and any earnings from the investments are tax-deferred. You only pay taxes when savings are withdrawn.
- Federal legal protection – 401k plans are protected by the Employee Retirement Income Security Act of 1974 (ERISA) the federal guidelines employers follow when managing their employees’ retirement accounts.
- Matching contributions – Many employers that offer a retirement plan also pay matching contributions. For example, your company might match 100% of what you contribute to your retirement plan up to 3% of your income.
- High annual contribution limit – For 2022, the allowable limit remains up to $20,500 per year.
- Possible limited investment options – Your 401(k) may have fewer investment options like basic asset classes such as stocks, bonds, and cash funds.
- Higher account fees – Because their administrative requirements are significant this results in higher fees. As a plan participant, you have little say in the fees you pay.
- Early withdrawal fees – There is a 10% fee for early withdrawals before the official retirement age of 59½. You typically can’t tap a 401(k) or 403(b) unless you have a qualifying hardship. That discourages participants from tapping accounts, so they keep growing.
A Roth 401(k) combines the rules of a 401K and a Roth IRA. Like a Roth IRA, an employee makes post-tax contributions, and any earnings grow potentially tax-free. Contributions are made with payroll deductions and have the same limits as a 401(k) of 20,500 in 2022.
Potential tax-free growth because just like a Traditional employer-sponsored 401k plan, the Roth 401k allows workers to make contributions through payroll deductions.
Contributions to a Roth 401k are made with after-tax dollars, which means when withdrawing the money during retirement, you don’t have to pay tax on it again.
- Pay taxes now like a Roth IRA – With a Roth 401(k), you choose to pay taxes now at your current income tax rates rather than deferring them to retirement.
- Roth 401(k) has a higher contribution limit than a Roth IRA – A Roth 401(k) is treated just like a Roth IRA, but it has a contribution limit about three times higher than a Roth IRA.
- Easy investing – Setting up a Traditional IRA or Roth IRA means you have to research a brokerage firm, different investment options, fill out paperwork to open the account, and either set up automatic contributions or remember to invest regularly. Investing in your workplace 401(k) is significantly easier.
- Fewer investing choices than an IRA – With a Roth 401(k), you are stuck with the investment options your company chooses to put into the plan. You could end up with great, low-cost index investments if your company chooses wisely, or you may end up with high-cost investments. With IRAs, you have more investment options.
- No penalty-free early withdrawals – Even though a Roth 401(k) is funded with the same kind of income (post-tax) as a Roth IRA, it is tied to the withdrawal rules of a regular 401(k). That means any early withdrawals before retirement are hit with a 10% early withdrawal penalty. A Roth IRA allows you to withdraw your contributions at any time, but you have to wait until retirement to withdraw any earnings.
- Cannot defer taxes until later – A Roth 401(k) requires you to pay taxes on the money at the time of contribution. A 401(k) allows you to defer the tax on your contributions until retirement when many people will have less yearly income, which results in a lower tax bracket. If you believe your income in retirement will be substantially lower than your current income, a Roth 401(k) may not be the best option for you.
A Solo 401(K) is also known as an individual 401(K) and is used by small business owners as a plan to save for retirement. Regarding your retirement account as a small business owner, you are both the employee and the employer. With an Individual 401(k), there is an employee deferral, and then also an employer contribution.
As a business owner, you can have a Solo 401(k) (providing you meet all the requirements) and you can make an employee deferral just like you can with a company you work for as well as the employer contribution component. Below we have listed some of the pros and cons of a Solo 401(k).
- As the employer, you can contribute up to $37,500 into your Solo 401(k), (if you maximize your employee deferrals), not to exceed 20 percent of your self-employment income or 25 percent of your W-2 income.
- If you are under the age of 50, as an employee, you can defer up to $19,500. Keep in mind, it’s up to 100 percent of your earned income, not to exceed $19,500.
- If you’re paying yourself enough, you could potentially get upwards of $57,000 if you’re under the age of 50 and up to $63,500 when you are over the age of 50.
- To qualify for a Solo 401(k), you cannot have any employees (other than your spouse), so if you have employees or want to have employees in the future, this plan is not for you.
- You are required by the IRS to file an annual report on Form 5500-SF if the account has $250,000 or more in assets at the end of the year. If you have less than $250,000, you may be exempt from the annual filing requirement.
- IRS requires contributions to a Solo 401(k) to be “recurring and substantial.” In general, this means you must make contributions somewhat regularly for the account to remain active.
A traditional Individual Retirement Account (IRA) allows you to direct pretax income toward investments which can grow tax-deferred until retirement withdrawals occur (at age 59½ or later. The IRS assesses no capital gains or dividend income taxes until the beneficiary makes a withdrawal. In most cases, contributions to traditional IRAs are tax-deductible. If someone contributes $6,000 to their IRA, for example, they can claim that amount as a deduction on their income tax return, and the (IRS) will not apply income tax to those earnings.
Individual taxpayers can contribute 100% of any earned compensation up to a specified maximum dollar amount. The contribution amounts are ($6,000 for 2021 and 2022 for those under age 50, $7,000 for those 50 and older), and required minimum distributions (RMDs) must begin at age 72.
- Tax-Free Growth – A traditional IRA offers tax-free growth of the assets. This means that once the money is in the account, no taxes are applied to the dividends or capital gains that the investments earn until distribution.
- Tax Deductions – While Roth IRA contributions are made with after-tax dollars, traditional IRA contributions are made with pretax dollars. This means they can be deducted from your income—in most cases—although there are certain limitations.
- Strict contribution limits – IRAs have strict contribution limitations. To contribute to an IRA, you or your spouse need earned income.4 For 2021 and 2022, the maximum contribution amount per person is $6,000, and those aged 50 and older can make a $1,000 catch-up contribution in 2021 and 2022.
- Penalties – Since the IRA is intended for retirement, there are often specific penalties if you take out your money before retirement age. With the traditional IRA, you face a 10% penalty on top of the taxes owed for any withdrawals before age 59½. With the Roth IRA, you can withdraw a sum equal to your contributions penalty and tax-free at any time.
- Required withdrawals – There are mandatory withdrawals for your traditional IRA called, minimum distributions (RMDs), starting when you reach age 72. The withdrawal amount is calculated based on your life expectancy, and it is added to that year’s taxable income.
A Roth IRA is an individual retirement account (IRA) that allows qualified withdrawals tax-free if certain conditions are satisfied. Roth IRAs are similar to traditional IRAs, with the most significant distinction being how the two are taxed. Roth IRAs are funded with after-tax dollars—this means that the contributions are not tax-deductible, but once you start withdrawing funds, the money is tax-free.
- Tax-free withdrawals – In retirement, when you decide to withdraw money, you will not have to pay taxes on it because taxes are paid on the money when you contribute funds to the account.
- No mandatory withdrawals – In traditional IRAs, you need to start taking money out by April 1 of the year after you turn 72. A Roth IRA has no mandatory withdrawal requirements. Roth IRA’s a great option if you don’t need to start making withdrawals once you hit a certain age. For example, if you’re still working and earning an income, your money can continue to grow in your Roth IRA account.
- No maximum age requirements for contributions – Roth IRAs have no age limitations on how long you can make contributions. In a traditional IRA, you have to quit making contributions at 70 1/2. And when you hit age 50, you can contribute even more through catch-up contributions.
- Limited penalties on early distributions – Since you have already paid taxes on your Roth IRA contributions, you can withdraw that money without incurring taxes or penalties at any time. However, you are still subject to a 10% tax penalty for early withdrawals on your earnings in the account.
- Contributions are taxed – Withdrawals are not taxed, but the contributions are. That means when you contribute to your Roth IRA, you have already paid taxes on the money. Other retirement accounts handle taxes differently and could be more beneficial depending on your tax situation. A 401(k) allows you to contribute money pretax, while a traditional IRA allows you to deduct contributions from your taxes.
- Limits based on income – Traditional IRAs do not have income limits, so you can earn as much as you want and still maintain one. Roth IRAs do have limits in place. If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $140,000 for the tax year 2021 and under $144,000 for the tax year 2022 to contribute to a Roth IRA, and if you’re married and file jointly, your MAGI must be under $208,000 for the tax year 2021 and 214,000 for the tax year 2022.
- Contribution limits are low – Traditional and Roth IRAs have the same maximum contribution limits, with the maximum allowable contribution to a Roth IRA in 2022 being just $6,000 for those below 50. If you are age 50 or older, you can make a Roth IRA catch-up contribution of $1,000 for a total of $7,000 in 2022. This amount has been the same since 2019.
A SIMPLE IRA (which stands for Savings Incentive Match Plan for Employees) is a start-up retirement savings plan for small businesses, usually reserved for companies with no more than 100 employees. SIMPLE helps small-business owners save for their retirement and contribute to their employees’ retirement savings. Many of the features of a SIMPLE IRA are the same as those of a traditional IRA.
- Flexibility – With some other employer-based retirement plans like a 401(k) or 403(b), you might have to work at that company for a certain number of years before what the company puts in belongs to you. Whatever money your employer contributes to a SIMPLE IRA is immediately vested. That means every dollar put into your account belongs to you, and you can take it with you whenever you leave the company.
- Less expensive and easier to operate – A SIMPLE IRA is much easier to set up and cheaper to run than a typical 401(k). That’s because they have lower administrative costs because there are fewer regulations on a SIMPLE IRA.
- Tax Advantages – If you own a small business and make contributions to employee accounts, there is a tax deduction for those contributions you make.
- There’s no Roth option for SIMPLE IRAs – There is no Roth IRA option available for SIMPLE IRA plans that allow employers and employees to enjoy tax-free growth and tax-free withdrawals in retirement.
- Withdrawal penalties – If you withdraw funds from a SIMPLE IRA or roll over into anything other than another SIMPLE IRA account within two years of opening it, there is a 25% penalty fee.
- Low contribution limits – SIMPLE IRA contributions max out at $13,500 for most workers. That’s a few thousand dollars less than the contribution limit for a regular 401(k) plan.
SEP Plan (Simplified Employee Pension)
A Simplified Employee Pension (SEP) is an individual retirement account (IRA) that an employer or a self-employed person can establish. The employer is allowed a tax deduction for contributions made to a SEP IRA and makes contributions to each eligible employee’s plan on a discretionary basis.
- High Contribution Limits – SEP IRA contribution limits are annual and often higher than standard IRAs and 401(k)s.
- Tax-free accumulation – Earnings accumulate with no immediate income tax obligations. Savings compound at a relatively high rate, giving you more money after retirement even after future taxes are paid on withdrawals.
- No tax liability on changing investments – A SEP is a vehicle you can use to manage a portfolio actively. All trades are made with no tax consequences. Many SEP providers offer a wide range of investment choices, such as exchange-traded funds (ETFs), containing a basket of stocks to help diversify the risk associated with investing in the equity markets.
- Catch-up contribution opportunities – SEP plans do not allow catch-up contributions such as those permitted with a Roth IRA.
- Required Maximum Distribution. SEP requires a maximum distribution (RMD) at the age of 72. RMD is the specific amount you must withdraw to avoid being penalized with fees. There is a table the IRS provides to figure your RMD for the current year.
Profit-Sharing Plan (PSPs)
A Profit-sharing Plan is a retirement plan that gives employees a share in a company’s profits. There may be restrictions on when and how these funds can be withdrawn without penalties. The profit-sharing plan gives employees a share in their company’s profits based on quarterly or annual earnings.
There are two major types of profit-sharing plans: deferred and cash. Deferred plans are typically used to get targeted employees to the annual IRS pretax contribution limit. This is most helpful if you want to attract employees you hope to retain for an extended period. In a cash plan, the company directly pays the employees’ bonus in after-tax dollars.
- Flexible contributions
- If the company does well you are compensated more
- Higher administrative costs than with other plans, such as with a SEP or SIMPLE IRA plans
- In-service withdrawal: There is a 10% early withdrawal penalty if taken prior to 59.5 years of age
Defined Benefit Plan
A pension plan is the most known type of defined benefit plan and is not as common as the 401(k), a defined contribution plan because 401(k)s have cheaper administrative costs and the employee bears the investment risk.
- If the plan is insured, the Pension Benefit Guarantee company guarantees most if not all of the earned benefit if the employer can’t afford to pay.
- May offer cost of living adjustments
- Tax-deferred savings
- No employee contributions and therefore no investment risk for the employee.
- Some plans don’t allow lump-sum payments.
- Benefits are usually not payable until the average retirement age.
- Typically won’t benefit an employee that leaves employment before retirement.
- The employee has no control of investments.
- Growth may be smaller than a defined contribution plan with no employee contributions.
- More costly to administer for the employer
Employee Stock Ownership Plan (ESOPs)
An ESOP allows an owner to sell the business to their employees, who then become shareholders. This can be an attractive option when you read about the potential tax benefits and implications for your employees but review the risks before proceeding. This type of plan is not a good move for every business. It is complex, expensive, and, to some companies, not viable.
- Built-in Buyer – For the large number of baby boomers looking to sell their businesses, an ESOP can solve the contentious issue of finding a buyer in a market on its way to saturation with businesses for sale.
- Employee Ownership Within Reach – For employees, this kind of plan represents an opportunity to take ownership of the company.
- High Expense – These plans are highly complex and comparatively expensive to administer. For the most straightforward strategy, an owner can expect to pay a minimum of $40,000 to get the paperwork and process started.
- Lower Valuation – When an ESOP purchases the shares of a business, it does so based on a theoretical valuation report from a qualified firm. This valuation can be significantly lower than what a competitive selling process could achieve with multiple interested buyers and investors.
A 457(b) retirement plan is similar to a 401(k) or 403(b) plan. It allows you to contribute part of your salary toward a retirement investment plan.
Your contributions to the retirement account are taken directly out of your paycheck. You don’t pay income taxes on the money you contribute until you withdraw money from your 457(b). You may face additional penalties if you take money out six months after your 59th birthday, with a few exceptions.
Employers who offer 457(b) plans include state and local government agencies and specific nonprofit organizations.
- Catch up Contributions – If you are within three years of the plan’s retirement age, you can double your catch-up contributions (total contributions of $39,000 per year in 2021.)
- Rollover options – You can roll over your 457(b) account into either an IRA or a 401(k) plan if you leave your job.
- Matching Contributions – The primary providers of 457(b) plans, few state and local governments – provide matching contributions.
- Limited total Contribution amount – If your employer matches your contribution, that money counts toward the typical total contribution limit of $19,500 for 2021
A cash balance plan is a type of defined benefit pension plan. Traditionally, defined benefit pension plans are funded to pay out a promised benefit for the remainder of one’s life in retirement. As a result, an actuary needs to run testing for the plan to ensure it is adequately funded to meet the promised benefits. If the account is underfunded, the business (or individual if self-employed) may be required to add additional monies to the account. If overfunded, future contributions may be limited.
- Pretax contributions – As mentioned already, you can make pretax contributions to a cash balance pension plan.
- High Contribution Limits – The contribution limits for cash balance pension plans are considerably higher than other retirement accounts. In the latter stages of one’s career, you could save upwards of $300,000 a year pretax into a cash balance plan.
- Limited Growth – Because cash balance plans are defined benefit pension plans, the employer is on the hook to ensure the end balance is promised. As a result, they intentionally set the target growth rate somewhat conservatively.
- High administrative costs – The underlying investment portfolio must be managed to achieve the target growth rate for the plan. Due to these factors, cash balance plans typically aren’t do-it-yourself investment accounts, as numerous professionals must implement and maintain them.
Nonqualified Deferred Compensation Plan (NQDC)
Nonqualified deferred compensation plans refer to a range of incentive plans offered to executive-level employees. The programs allow employees to defer compensation to a specified point in the future. Employees also defer paying taxes on that compensation until they receive it—typically years down the road and often post-retirement. However, unlike 401(k)s, NQDCs don’t have contribution limits, making them even more enticing to high-earning employees, who may quickly max out an employer-sponsored qualified retirement plan.
- No contribution limits – Suppose you earn a substantial income and want to save significantly more than your 401(k) limit.
- Flexible payout options – Depending on the plan design, you can typically choose either a lump-sum distribution or opt to take withdrawals over a period of 5-10 years. This offers far greater flexibility than 401(k) or IRA accounts.
- Lack of investment diversification – As a senior executive, there’s a strong likelihood you may already be too heavily weighted in your own employer’s stock. If things go badly for the company, your NQDC assets are in jeopardy.
- Unexpected payout acceleration – Even if you choose a flexible payout option over time, the company may have a right to accelerate your payout should you unexpectedly leave. This means you could suddenly receive a large sum of money when you’re not expecting it, resulting in significant tax implications.
Payroll Deduction IRAs
A Payroll deduction IRA is an individual retirement account funded with automatic contributions from an employee’s paycheck. Payroll deduction IRAs operate similarly to 401(K)s and other workplace retirement plans: Workers can elect to contribute a percentage or set dollar value from each paycheck and have their tax withholdings adjusted accordingly.
Payroll deduction IRAs function like regular individual retirement accounts, offering a vast range of low-cost investment options. For employers who can’t afford to offer other retirement plans, payroll deduction IRAs provide a way to encourage workers to save for their futures. And for employees who aren’t covered by workplace plans, payroll deduction IRAs can help simplify saving for retirement.
- Easy to set up and operate
- Low administrative costs
- No government filings required
- No employer contributions
- No Business Deduction
- Cannot take a loan like you can from a 401(k)
Guaranteed Income Annuities (GIAs)
An annuity is a financial product that a consumer might use to help manage their money during retirement. When you purchase an annuity, usually from an insurance company, you enter into a contract with the company and make a payment (or multiple payments).
When it’s time to pay out the funds, the insurance company pays you. These payments may also include interest earned on your money, which grows tax-deferred until payout. The type of payout — generally a lump-sum or series of payments — you’ll receive varies based on the payment structure outlined in the contract with the insurance company and the type of annuity you purchase. Guaranteed annuities are investments that provide a guaranteed rate of return for a set number of years.
- Retirement income for life – If you’re worried about outliving your money during retirement, an annuity can provide a steady stream of income for a set time, which may extend and help to avoid that from happening.
- Fixed annuities offer guaranteed returns – When you invest in a fixed annuity, you’re guaranteed to earn a minimum amount of interest on your investment. While interest rates tend to be lower, they’re somewhat predictable.
- Limited access to your money – Many annuities have a surrender period, during which you can’t withdraw money without incurring hefty fees. Once you choose to start receiving annuity payments from your investment, many companies will no longer let you withdraw money from your account.
- Fees and penalties – Many annuities have fees attached to them to minimize the return you earn on your investment.
Cash-Value Life Insurance Plan
Cash-value life insurance is a form of permanent life insurance that features a cash value savings component lasting for the holder’s lifetime. The policyholder can use the cash value for many purposes, such as a source of loans or cash or to pay the policy premium.
- Taxes are deferred on earnings until withdrawn from the policy and distributed. Once distributed, profits are taxable at the policyholder’s standard tax rate.
- Most cash-value life insurance policies allow for loans from the cash value. The issuer will charge interest on the outstanding principal as with any other loan.
- Higher cost – Compared with term life insurance, whole life insurance is costly
- Lack of investment control – The insurance company invests the cash value part of your policy in whatever way it chooses
TSP (Thrift Savings Plan)
A thrift savings plan (TSP) is a tax-deferred retirement savings and investment plan open only to federal employees and members of the uniformed services. It offers many of the same benefits that are available to workers in the private sector under a 401(k) plan.
The TSP has the same contribution limits and early withdrawal penalties as a 401(k). The two plans differ when it comes to investment choices, with a TSP offering fewer fund options than a typical 401(k).
- Lower fees – Annual administrative expenses for TSP funds average less than 0.05% of the amount invested. In 2021 the average 401k plan had fees ranging from 0.88% – 1.19%.
- Automatic enrollment – Federal employees are automatically enrolled in the plan.
- Matching contributions – The employer will match employee contributions up to 5% of the employee’s salary.
- Limited investment choices – 401(k) plans offer a wider selection of investments giving them more flexibility with your retirement.
- Inflexible withdrawal options
How to choose
Once you understand the options available for your retirement plan, you can take steps to make the best decision based on your financial goals. There are multiple factors to consider when making your decision, and we will discuss them below.
Life expectancy is longer, which means you’ll need your money to last longer – potentially into your 90s. The age you want to retire at will also affect what retirement plans you should consider. If you have a physically demanding or time-consuming job that keeps you away, you may not be able or want to work as long as someone who has flexibility in their career.
What are your goals?
Saving for retirement is balancing between deciding what your goals are now and 30 years from now. FOr instance, this year, you may want to purchase a new truck, but with higher costs on vehicles and gas, this will cut into what you can put aside for retirement. This is a situation where you weigh how essential a new car is or if your current vehicle can make it another year or
Is it more important for you to have a new car every 2 years now or a second home in a warmer climate when you retire? Sit down and think about your current and future goals and see where you can make the appropriate balance.
Budgeting is essential to save for retirement and invest a comfortable amount into your retirement plan. Budgeting goes along with goals. Once you have your goals laid out, it is time to assess your budget and meet those goals.
My personal goals may differ from yours. I plan 2 vacations a year into my budget instead of investing that extra money into a retirement account. I prioritized family vacations with my children above the extra funds into my savings. It is a balancing act and can continually be readjusted as your goals and income change.
Understanding the different retirement plans available will allow you to assess your financial situation and make the appropriate choices on which plan will work best for you. Researching the options that will work with your financial goals can help you maximize your return on investment and avoid hefty fees by choosing a plan that does fit your financial circumstances.