In the United States, it is quite common for individuals to leave it up to their employers to kick start the retirement planning efforts of the individual by enrolling them in a 401(k) or other employer-sponsored retirement plans. However, there are many plans beyond your standard 401(k) plan that could potentially do a better job of helping you save for retirements.
What are the different types of retirement plans? The plans below are your best options based on the key benefits, yearly contributions, and withdrawal requirements.
Retirement Accounts for Individuals
Traditional 401(k) Plan
A traditional 401(k) plan is the most common option that is offered by many employers to their employees. The 401(k) plan was first introduced to phase out the more expensive pension plan.
Designed For: W2 employees working for companies offering a 401(k) plan.
Key Benefits:
- The plan is easy to set up. You work with your HR department to set up an automatic deduction from your paychecks, and the money is automatically invested in various investments based on your chosen funds selection.
- Your contributions are tax-deductible against your income, so you pay less taxes each year.
- If you are lucky enough, you will find a company that offers a generous company match, which is basically free money.
- The contribution limit is relatively high compared to traditional and Roth IRA.
Disadvantages:
- Investment fees and plan fees tend to be higher than average brokerage fees.
- Investment choices tend to be very limited.
Contribution Limit: For 2020, the limit is set at $19,500 (or $26,000 if you’re 50 years old or above).
Withdrawal:
- You can begin penalty-free withdrawals from your 401(k) accounts after age 59 1/2, and the IRS requires withdrawals after age 72 (called Required Minimum Distribution).
- Early withdrawals are subject to a 10% penalty.
- Your withdrawals are subject to income taxes.
Roth 401(k) Plan
A Roth 401(k) is a relatively new alternative to a traditional 401(k) plan. With a Roth 401(k), your contributions are not tax-deductible (so there are no tax savings now); however, your withdrawals are tax-free — everything that you earned from now through retirement is not taxable!
Designed For: W2 employees who are willing to pay taxes now to avoid paying taxes at withdrawals.
Key Benefits: Same as a traditional 401(k) plan, but the withdrawals are tax-free.
Disadvantages: Same as a traditional 401(k) plan.
Contribution Limit: Same as a traditional 401(k) plan.
Withdrawal:
- You can begin penalty-free, tax-free withdrawals from your Roth 401(k) accounts after age 59 1/2 and have held your account for at least five years.
- Early withdrawals are prorated between nontaxable contributions and earnings, and unqualified withdrawals are subject to the 10% penalty.
- The IRS requires withdrawals after age 72 (called Required Minimum Distribution).
Traditional IRA
If you don’t have access to a 401(k) plan, your next best option is an IRA (stands for Individual Retirement Account). IRA also comes in two flavors: Traditional and Roth. And for those who qualify, you can contribute to both your 401(k) plan(s) and IRA in the same year — just make sure your consult with your tax advisor to make sure you are within the phase-out and contribution limits.
Designed For:
- Ideal for individuals who want to save for retirement and make tax-deductible contributions to reduce their tax bills.
- This is also the best account to rollover your traditional 401(k) accounts from previous employers.
Key Benefits:
- You can open an IRA with any brokerage firm and have access to almost any investment you want.
- If you can make deductible contributions, you will be able to reduce your tax bills with a traditional IRA.
- The tax is deferred while your money grows, and this makes a significant difference in your investment growth over time.
- You can always contribute to a Traditional IRA because there is no income limit; however, tax-deduction is phased out for high-income earners.
Contribution Limit: For 2020, The limit is set at $6,000 per individual (or $7,000 per individual if you’re 50 years old or above).
Withdrawal:
- You can begin penalty-free withdrawals from your traditional IRA after age 59 1/2, and the IRS requires withdrawals after age 72 (called Required Minimum Distribution).
- Early withdrawals are subject to a 10% penalty.
- Your withdrawals are subject to income taxes.
Roth IRA
A Roth IRA is similar to a Traditional IRA in almost all aspects with the following key exceptions (1) contributions are not tax-deductible, (2) contributions are phased out based on income, and (3) your withdrawals are tax-free.
Designed For: Same target audience as a traditional IRA, but for savers who are willing to pay taxes now to avoid paying taxes at withdrawals.
Key Benefits:
- You can open an IRA with any brokerage firm and have access to almost any investment you want.
- Withdrawals are tax-free.
- There is no Required Minimum Distribution.
Contribution Limit: For 2020, The limit is set at $6,000 per individual (or $7,000 per individual if you’re 50 years old or above).
Withdrawal:
- You can withdraw contributions you made to your Roth IRA anytime, tax-free and penalty-free.
- You can withdraw earnings tax-free and penalty-free after you turn 59 1/2 and have held your account for at least five years.
403(b) Plan
A 403(b) plan, also called the tax-sheltered annuity plan, is designed for employees of public schools, tax-exempt organizations, ministers, and employees included in the Code Section 501(c)(3). Traditional and Roth 403(b) plans work exactly the same way as a traditional and Roth 401(k) plan, respectively.
TSP
TSP, also known as the Thrift Savings Plan, this investment account is designed for the members of uniformed services and employees of the federal government. It is a defined-contribution plan that is similar to the traditional 401(k) retirement plan. Traditional and Roth TSPs work exactly the same way as a traditional and Roth 401(k) plan, respectively.
Retirement Accounts for Business Owners and Self-Employed Individuals
Solo 401(k)
A Solo 401(k) is a limited 401(k) plan designed for solo business owners.
Designed For: This plan is designed for individual business owners with no employees. The plan can also accommodate the owner’s spouse.
Key Benefits:
- You can choose between traditional Solo 401(k) or Roth Solo 401(k), or both. In a traditional plan, you will enjoy tax savings today, your portfolio grows tax-deferred, and you pay taxes at the time of withdrawals. In a Roth plan, you pay taxes today, but the withdrawals are tax-free.
- Easy to set up and manage.
- Extremely high contribution limit.
Disadvantages:
- Fees can add up quickly if you want access to more investment choices.
- They have limited investment choices.
Contribution Limit:
- For 2020, employees can contribute up to $19,500 (or $26,000 if you’re 50 years old or above).
- You can also contribute to the plan as an Employer. The total combined contribution cannot exceed $57,000 (or $63,500 if you’re 50 years old or above).
Withdrawal: Same as a traditional 401(k) plan or Roth 401(k) plan.
SEP IRA
A SEP IRA, also known as Simplified Employee Pension, is designed for small business owners who want to build a retirement fund for their employees, self-employed, and any employee if applicable.
Designed For: Business owners and their employees, or self-employed individuals.
Key Benefits:
- Contributions are tax-deductible. This plan will help you lower your taxable income.
- Your money will grow tax-deferred, i.e., no taxes until you withdraw your money.
- Most brokerage firms can help you set up and manage SEP IRA accounts at a minimal cost.
- You and your employees have access to a wide variety of investment choices.
- Extremely high contribution limit.
Disadvantages:
- Only the employers, or self-employed individuals, can contribute to a SEP IRA.
- Employees cannot contribute to a SEP IRA.
- Every employee must receive the same percentage of contribution. From an employer’s perspective, this could be relatively burdensome and expensive.
Contribution Limit: Employers and self-employed can contribute up to $57,000 or 25% of the employee’s compensation, whichever is lower.
Withdrawal:
- You can start withdrawing penalty-free after you turn 59 1/2.
- For early withdrawals, there is a 10% penalty in addition to the applicable income tax liability. The penalty is waived in some situations, including the death of the account owner, higher education expenditures, disability, IRS tax levy, equal payments, and military qualifications.
Simple IRA
A Simple IRA, also known as Savings Incentive Match Plans for Employees, are usually set up by employers for their employees. Both are encouraged to contribute to the plan. This is a good alternative for small companies that do not want to use a SEP IRA and can’t afford a full-blown 401(k) plans yet for their workers.
Designed For: Business owners and their employees, or self-employed individuals.
Key Benefits:
- Both employers and employees can make tax-deductible contributions with lower administrative costs.
- Most brokerage firms can help you manage SEP IRA accounts at a minimal cost.
- You and your employees have access to a wide variety of investment choices.
Contribution Limit:
- For 2020, employees can contribute up to $13,500 (or $16,500 if you’re 50 years old or above).
- Employers can contribute in one of two ways:
- Match up to 3% of the employee’s annual contribution, or
- Offer non-elective 2% contribution of each employee’s salary without requiring employee contributions.
Withdrawal:
- You can start withdrawing penalty-free after you turn 59 1/2.
- For early withdrawals, there is a 10% penalty in addition to the applicable income tax liability. This penalty increases to 25% if you have the account for less than two years.
Alternative Retirement Plans
HSA
Unlike the standard retirement plans mentioned above, HSA or Health Savings Account has the primary purpose of saving for medical expenses. However, this is a very flexible plan, and many savvy savers are using it as a booster to their regular retirement accounts.
Designed For: W2 employees working for companies offering an HSA account.
Key Benefits:
- Your contributions are tax-deductible.
- Money in your HSA does not expire at the end of the year. You can keep them as long as you want to.
- The money in your account is yours to keep even if you change jobs.
- HSA can be used for a broader range of expenses, limited only by legislation and IRS guidelines.
Disadvantages:
- Investment choices tend to be very limited.
Contribution Limit: For 2020, The limit is set at $3,550 per individual or $7,100 per family. After the age of 55, members can contribute an additional $1,000 towards their HSA (either individual and family coverage).
Withdrawal:
- You can use your HSA money at any time for eligible medical expenses, and you do not pay tax on the withdrawal.
- If you become disabled or reach age 65, withdrawals can be made for non-medical reasons without penalty, but amounts must be reported as taxable income. Effectively, your HSA works like a Traditional IRA at this time.
For more information, read Introduction to Health Savings Account (HSA).
Homeownership
Although homeownership is not specifically a retirement account, it has many benefits and can potentially be used as an alternative retirement savings vehicle. This is especially true if the cost of owning a home is less than what you’re currently paying for rent.
Designed For: Anyone with the qualification to get a home loan.
Key Benefits:
- When you own a house that costs you less than renting, you are essentially living for free in your retirement account!
- Relatively fixed housing costs. Since your principal and interest payments do not go up, you are only paying for the increases in property tax and insurance premiums. On the other hand, your rent will likely increase every year, and moving expenses can significantly add to your housing costs.
- Home value appreciation. Over 15 to 30 years, your home value will appreciate 2-5% on average. But your home is a leveraged investment (e.g., you only spent $50,000 to buy a $250,000 house), your actual return on investment can easily be in the range of 10-20%
- Forced savings. Each time you make a mortgage payment, a portion of that money goes toward paying down your principal balance. In essence, this is the same as putting money into a savings account.
- Tax deduction. You might be able to realize some tax savings if your itemized tax deduction is greater than the standard deduction. With your home, you can deduct the mortgage interest and property tax paid during the year.
Disadvantages:
- Your house is a physical asset, and it will require repairs and maintenance. This is basically your investment expenses.
Withdrawal:
- You can sell your house at any time. Usually, the breakeven point is around 4-7 years, and after that, you should realize a profit.
- Up to $250,000 of profit on the sale of your primary residence is tax-free. This amount increases to $500,000 for a married couple.
- You can take out a home equity loan or do a cash-out refinancing to access your equity.
- You can convert your house to a rental property. If the numbers work out, you should have a cash flow generating rental property that can provide you with regular income.
Bottom Line
A properly designed retirement plan using the right combination of retirement accounts will make your financial future much more secure. It is also an important element of tax savings that you just do not want to miss.
The critical thing to remember is that there is no “one size fits all” retirement plan that is best, or even accessible, for everyone. What plan is available to you, what type of organization you belong to, how many employees you have, how much money you would like to contribute to a plan, and many other factors will help you to determine which option is best for you.
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Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.
