This post will review the different types of retirement plan options, highlighting the pros and cons of each one and when it might be ideal to use.
If you are anything like me, you probably feel so overwhelmed by all the different types of retirement plan options available that you don’t even know where to start. Even worse, you don’t even want to get started. When this is the case, the easy solution is to go with the basic or recommended option provided with your employer sponsored retirement plan. Upon hire you set your level of investment risk and your contribution percentage, then forget about it forever more.
However, you know the old saying, “Pay yourself first”. Without adequately paying yourself and your retirement first, do you know what your retirement will look like? Do you have a dependable pension plan? Can you rely on social security payments to help supplement your retirement? Do you know when you will be able to retire? What will your healthcare look like in retirement, will you be prepared for high health expenses? And most importantly, will your lifestyle need to dramatically alter in order to adjust to what you have available?
These are difficult questions to answer without some knowledge of your retirement plan options and how to best utilize the options available to you. But that’s okay, in the post I will review the main different types of retirement plan options, whether you are working for a large employer, self-employed as a business owner or contractor, or a stay-at-home mother. This will provide an understanding of the different plans and how/why you would want to choose one over another.
Different Types of Retirement Plans
Employer Sponsored Retirement Account
Definition: Types of plan offered includes 401(k), 403(b), and 457(b). Money is contributed tax-deferred and grows tax-free, similar to an IRA.
Pros: Often employer matching is available, which is free money to you. In certain cases you have the ability to borrow penalty-free. Also, there are often limited investment selections based on risk tolerance, which makes management easy for the novice investor.
Cons: Investment options are limited, more so than with an IRA, which could narrow down personal investment goals and remove flexibility for the educated investor.
Contribution Limits: $18,500, or, $24,500 if 50 years or older. Employer contributions are not included in this amount.
When to use: When your employer offers a 401(k), especially beneficial when the employer offers matching contributions.
Note: If you contribute the full $18,500 and you make between $82,501 – $157,500, that’s $4,440 that you don’t have to pay in taxes. This is a significant tax savings and an additional benefit to aggressive retirement savings.
Self-Employed 401(k)
Definition: Also called Individual 401(k), Solo 401(k) or Indi-K. This plan is available for an individual running a sole-proprietorship or a small business with a spouse or other close family member.
Pros: Contribution limits are the same as company sponsored retirement accounts, however, the individual may also make an employer contribution to the individual account, raising the total allowable contribution. Contributions are tax-deductible or, if incorporated, considered a business expense. Plan functions much like a SEP IRA, however, it is easier and cheaper to establish and manage. This plan also allows for personal loans, similar to a traditional 401(k).
Cons: No outside employees can be hired.
Contribution Limits: Contributions as the employee are limited to the lesser of either $18,500 ($24,500 if 50 years or older) or 100% of total compensation. Additional contributions can be made as the employer of up to 25% of compensation, up to $55,000 combined contributions if under 50, or $61,000 if 50 or older.
When to use: Individuals earning less than $220,000 will likely be able to contribute more compared to a SEP or SIMPLE IRA.
Traditional IRA
Definition: An individual retirement account that is taxed only when money is withdrawn.
Pros: Deposits and earnings grow tax free, allowing for a high rate of growth.
Cons: You must have earned income in order to make a contribution, there are lower contribution limits, and tax benefits depend on income level and tax-filing status.
Contribution Limits:$6,000 in 2020, with an additional $1,000 catch-up contribution if age 50 or older, making the total allowable contribution $7,000.
When to use: In place of employer offered retirement account, in addition to employer offered retirement account, up to maximum contribution limit or tax benefits depending on income and filing status.
Spousal IRA
Definition: An IRA that allows a working spouse to contribute to a non-working spouse’s retirement account. Most retirement accounts require income earnings greater than or equal to the yearly contribution, this is a useful way around this limitation. The account can be an individual or ROTH IRA and is subject to the same contribution limits.
Pros: Allows a non-working spouse to save for retirement
Cons: The working spouse’s income must be equal to or greater than the total contribution. The couple must also file jointly.
Contribution Limits:$6,000 in 2020, with an additional $1,000 catch-up contribution if age 50 or older, making the total allowable contribution $7,000.
When to use: When a married couple files a joint tax return and one spouse earns an income and the other does not.
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ROTH IRA
Definition: Allows you to contribute with after-tax money and withdraw tax free in retirement
Pros: Allows you to contribute more money towards retirement in addition to tax-deferred retirement accounts.
Cons: Subject to income limitations and phase-out tax benefits. This means that if you make over a certain limit, you no longer receive tax-benefits for your contributions.
Contribution Limits: $6,000 in 2020, with an additional $1,000 catch-up contribution if age 50 or older, making the total allowable contribution $7,000.
When to use: After you have maxed out the benefits or contributions to tax-deferred 401(k) and IRA accounts.
SIMPLE IRA
Definition: Stands for Savings Incentive Match Plan for Employees. This plan can be used by small businesses with 100 or fewer employees (too small to offer a 401(k)). Employers can enable a mandatory 2% contribution for employees or offer matching up to 3%.
Pros: Retirement account option when working for a small company, allows tax-benefits for the employer and requires minimal costs and paperwork to establish.
Cons: Lower contribution allowance, employees must earn a minimum of $5,000, funds can’t be rolled over into a traditional IRA until two years from plan start date. Additionally, SEP and traditional IRAs can’t be rolled over into SIMPLE IRAs.
Contribution Limits: $12,500 in 2018, with an additional catch-up contribution of $3,000 if age 50 or older.
When to use: In place of a 401(k) when working for a small business.
SEP IRA
Definition: Stands for Simplified Employee Pension. This option is a tax-deferred retirement plan for an employer or self-employed business owner. Contributions are made by the small business into a traditional IRA account for the benefit of the employee, usually the sole-proprietor.
Pros: High annual contribution limit compared to a traditional IRA. The employer can skip contributions during low or non-profit years.
Cons: No catch-up contributions if age 50 or older, more paperwork and a little more difficult to set up and calculate annual contributions and deductions.
Contribution Limits: Maximum contribution of 25% of earned income or $55,000 for 2018.
When to use: If you are a self-employed contract worker or sole-proprietor.
Others
HSA: Health Savings Account
Definition: A tax-advantaged account for individuals with a high-deductible health plan (HDHP). This allows you to save for qualified medical expenses that are not covered by the medical plan, including medical, dental, vision, prescription and over-the-counter medications. The HSA is usually paired with the HDHP and is typically offered through the health insurance company.
Pros: There are tax advantages and this plan saves money when deductible expenses are high. Employers can also contribute, but this is included in the total contribution limits.
Cons: Low maximum pre-tax contribution limits.
Contribution Limits: $3,450 for an individual or $6,900 for a family for 2018. Individuals 55 or older can add an additional catch-up $1,000.
When to use: If you have a HDHP, meaning your deductible is between $1,300 – $6,550 for individuals or $2,600 – $13,100 for families.
Self Directed IRA (SDIRA):
Definition: An IRA in which the individual is responsible for all investment decisions allowing for greater diversification of assets.
Pros: Offers a wide range on investment options including real estate, precious metals, private lending, private equity (such as investing in start-ups or starting your own business) and many more. The IRS specifies what you cannot invest in, everything else is allowable.
Cons: Requires knowledge and diligence to self-manage.
Contribution Limits: $6,000 in 2020, with an additional $1,000 catch-up contribution if age 50 or older, making the total allowable contribution $7,000.
When to use: For the savvy investor looking for a wider range of investment options.
Related Reading: 11 Steps to Rock Your Employer-Sponsored Retirement Plan
Summary of Options
If you work for an employer with 101 or more employees
- 401(k) if private
- 403(b) if public educational institutions (public schools, colleges and universities), certain non-profit organizations, and churches or church-related organizations
- 457(b) for some state and local government agencies and certain non-profit organizations
- Traditional IRA
If you work for an employer with 100 or fewer employees
- SEP IRA
- SIMPLE IRA
- Traditional IRA
If you are a Sole-Proprietor or Self-Employed
- SEP IRA
- Individual 401(k)
- Traditional IRA
- ROTH IRA
If you are non-employed and your spouse works
- Spousal IRA
If you already maxed out employer sponsored or IRA contributions
- ROTH IRA
For the savvy investor with diversified investments outside traditional stocks, bonds and mutual funds
- Self-Directed IRA
Recap
Don’t let the overwhelming number of choices and confusing names prevent you from finding the right retirement plan for you.
Whether you are working for a large employer, self-employed as a sole-proprietor or a contractor, or a stay-at-home mom, there is at least one plan that will help you on your path to retirement. In some cases there is even a supplementary plan that can move you along faster to retirement and offer additional tax benefits. (More on this later!)
ACTION STEPS
First, review what type of plan you have now and optimize it in order to ensure that your investment strategy and contributions are in line with your retirement goals.
See 11 Steps to Rock Your Employer-Sponsored Retirement Plan for more on how to accomplish this step.
Second, review the “Summary of options” section of this post. Which type of working situation do you fit into? Are there any plans listed that you didn’t know about but feel you may benefit from? If so, do some more research. Check out Vanguard.com or Fidelity.com, each site does a good job outlining the different plan options and offers assistance if you have additional questions.
If you aren’t sure how best to plan for your retirement, you can read more about retirement and early retirement planning in the following posts:
Happy retirement planning!
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