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Explaining 6 Key Types of Retirement Plans

Want to know more about retirement planning? Discover the different types of retirement plans and their tax advantages that help you save.

By Mike Faden | American Express Credit Intel Freelance Contributor

9 Min Read | March 18, 2020 in Life

 

At-A-Glance

Retirement plans provide tax advantages, encouraging you to save for retirement.

Different types of retirement plans vary in the kind of tax benefit they provide, as well as in contribution limits and withdrawal rules.

Some retirement plans are designed for employees, others for business owners or self-employed people—and some are available to anyone.

We all know we should save for retirement. To inspire us to do so, Uncle Sam provides tax incentives that encourage us to sock away money in a variety of different types of retirement plans. But here’s the catch: Understanding the different types of retirement plans can be challenging—particularly since they have confusing names, like 401(k) and SEP IRA.

 

To help you navigate your options, here’s a comparison of six of the most common types of retirement plans:

  • 401(k) 
  • Traditional IRA
  • Roth IRA
  • SEP IRA
  • Simple IRA and Simple 401(k)
  • Solo 401(k) 

 

How These 6 Types of Retirement Plans Differ

These retirement plans differ in many ways, but most importantly in the following key aspects:

  • Tax advantages: some plans offer tax benefits when you put money into the plan, others when you withdraw the money  
  • Contribution limits: the maximum amount you can save each year
  • Withdrawal rules: when you can withdraw money from the plan without penalty, and applicable penalties for non-compliant withdrawals

 

401(k): The ‘Standard’ Employee Retirement Plan

401(k) pros:

  • An easy option if you’re an employee
  • Employer matching contributions
  • High contribution limits

401(k) cons:

  • Limited investment options
  • It may take several years before you fully own your employer’s matching contributions

 

If you’re an employee, your employer’s 401(k) could be a very convenient retirement plan option since companies usually strive to make them easy to set up and manage.1 A 401(k) is a retirement plan offered by many for-profit companies as an employee benefit. Generally, you can contribute simply by diverting part of your paycheck into the retirement plan.

 

Like most other types of retirement plan, a 401(k) provides tax advantages by reducing your taxable income. For example, if you earn $60,000 in one year and contribute $5,000 to a 401(k), you won’t pay income tax on the portion you contributed.

 

Tax-free growth. The money in your 401(k) grows tax-free until you choose to withdraw it, at which time you’ll pay income tax on the money you take out. As with most other types of retirement plan, you have to be 59½ or older to withdraw money without penalty, and you’re required to start withdrawing money at age 70½. 

 

Matching contributions. A big attraction of 401(k) plans is that many employers provide matching contributions when you put money into the plan. That’s potentially free money. The catch: you may only earn the employer-contributed portion over several years (a process called “vesting”). If you leave the company before becoming “fully vested,” you’ll keep all your contributions but may get only a portion of your employer’s contributions. If you switch employers or retire, you can “roll over” your contributions to another company’s 401(k) plan or another type of retirement plan.   

 

High contribution limits. Another attraction of 401(k) plans is the relatively high contribution limit: you can contribute up to $19,000 in 2019, or $25,000 if you're 50 or older. The total contribution limit, including both employer and employee contributions, is $56,000 (or $62,000 for over-50s). 

 

Limited investment choices. A disadvantage of 401(k) plans is that you usually have a limited number of investment choices within the plan, such as mutual funds. 

 

Traditional IRA: A Retirement Plan for Anyone

Traditional IRA pros:

  • Available to anyone
  • Many plan and investment choices

Traditional IRA cons:

  • Low contribution limits

IRA stands for Individual Retirement Arrangement. As the name suggests, traditional IRAs are tax-favored savings plans that are mostly opened and managed by people themselves. Almost anyone under the age of 70½ can contribute to a traditional IRA, so an IRA may be appealing if you don’t have access to an employer’s 401(k).

 

Many aspects of a traditional IRA are similar to a 401(k), including the way the tax advantages work. Your contributions reduce your taxable income, the money grows tax-free until you withdraw it, and there are similar age restrictions for contributions and withdrawals.

 

However, there are also big differences between traditional IRAs and 401(k) plans. Contribution limits are much lower: $6,000 in 2019, or $7,000 if you're 50 or older. On the other hand, you can choose between many IRAs from different financial-services companies, and each plan may include a much wider range of investment options, including stocks as well as mutual funds.

 

In some cases, you may be able to contribute to both an IRA and a 401(k) in the same year, but be careful: your IRA contributions may not be tax-deductible unless your income is below a threshold amount.2

 

Roth IRA: A Different Type of Retirement Plan Tax Advantage

Roth IRA pros:

  • You could pay less tax overall
  • You can withdraw retirement savings tax free
  • More flexible contribution and withdrawal age limits 

 

Roth IRA cons:

  • No tax break for contributions
  • Income restrictions
  • Low contribution limits 

The biggest difference between a Roth IRA and a traditional IRA is when you get the tax benefits. With a traditional IRA, you pay no income tax on your contributions, but you pay tax when you take the money out. With a Roth IRA, it’s the exact opposite: you pay taxes on the money that you contribute, but you can withdraw money tax-free at retirement—so every dollar in your account goes into your pocket. 

 

Should you pick a traditional or Roth IRA? One big factor is whether you expect to be taxed at a higher or lower rate when you retire, experts say. Many people expect a lower tax rate after retirement because their income is lower. If you’re one of them, you might be better off with a traditional IRA; if not, you could pay less income tax overall with a Roth IRA.3

 

There are other differences between a Roth IRA and a traditional IRA. For example, you don’t have to start withdrawing money at age 70½, and you can withdraw some money early without penalties (although there are restrictions). Also, you can only contribute to a Roth IRA if your income is below a specific threshold ($137,000 in 2019, for example), unlike with a traditional IRA. In other aspects, including contribution limits, Roth IRAs are similar to traditional IRAs. To explore the similarities and differences in more detail, see the IRS comparison table

 

SEP IRA: For Small Business Owners and the Self-Employed

SEP IRA pros:

  • High contribution limits
  • For employees, immediate vesting can be an advantage 

SEP IRA cons:

  • For employers, immediate employee vesting may be a disadvantage

 

A SEP IRA (SEP stands for simplified employee pension) is a specialized type of IRA used mainly by self-employed people or small business owners, though technically it can be used by any size company. For employers, these retirement plans may be easier and cheaper to operate than traditional 401(k) plans.

 

In some respects, a SEP IRA operates similarly to a traditional IRA. But a big advantage of a SEP IRA is the ability to stash away much bigger retirement savings each year than with a traditional IRA. An employer can contribute up to 25% of each employee’s income up to a maximum of $56,000 in 2019. If you’re self-employed, you can contribute up to 25% of net income up to the same limit. Unlike with a 401(k), employees are always immediately 100% vested in employer contributions—which could be seen as an advantage if you’re an employee, or a disadvantage if you’re an employer trying to maximize employee loyalty.4

 

Simple IRA: A Simpler Small Business Retirement Plan

Solo 401(k) pros:

  • You may be able to contribute more than with other individual retirement plans
  • Some plans allow either traditional pre-tax or Roth (after tax) contributions

 

Solo 401(k) cons:

  • Limited investment options, like regular 401(k) plans
  • May be more complicated to set up than IRAs 

 

Solo 401(k) plans, also known as individual or one-participant 401(k) plans, can help maximize retirement savings for self-employed people and business owners that don’t have employees. They work a bit like regular 401(k) plans, except that you can boost your savings by contributing as both employer and employee.

 

As an employee, you can contribute up to 100% of self-employment income, to a max of $19,500 in 2020 or $26,000 if you’re age 50 or over. Then you can put on your employer hat and chip in up to an additional 25% of your business’ income (or around 20% if you operate as a sole proprietor, according to experts).5  Depending on your income level, this dual contribution formula may let you contribute more than with other retirement plans, such as SEP IRAs, although the maximum contribution limits are the same  ($57,000 if 50 or under/$63,000 if older).  

 

The Takeaway

Retirement plans all provide tax advantages as incentives to save for retirement. The various types of retirement plan differ in aspects such as when you pay income tax, contribution limits and withdrawal rules. Some plans are designed for employees, some are for solo proprietors and business owners, and some are available to anyone. But any individual may or may not be eligible for these plans’ tax advantages, due to their many variables—so it’s important to consult a professional tax advisor about your specific circumstances.

Mike Faden

Mike Faden has covered business and technology issues for more than 30 years as a writer, consultant, and analyst for media brands, market-research firms, startups and established corporations.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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