By Mike Faden | American Express Credit Intel Freelance Contributor
9 Min Read | February 1, 2022 in Money
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:
These retirement plans differ in many ways, but most importantly in the following key aspects:
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. 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 72.
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 $20,500 in 2022, or $27,000 if you're 50 or older. The total contribution limit, including both employer and employee contributions, is $61,000 (or $67,500 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 pros:
Traditional IRA cons:
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 with taxable income 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 2022, 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.
Roth IRA pros:
Roth IRA cons:
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.
There are other differences between a Roth IRA and a traditional IRA. For example, you don’t have to start withdrawing money at age 72, 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, 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 pros:
SEP IRA cons:
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 $61,000 in 2022. 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.
Simple IRA pros:
Simple IRA cons:
A simple IRA is another type of employee retirement plan, for small businesses with 100 or fewer employees. If you’re an employee and you participate in your employer’s Simple IRA, you’ll generally receive some contributions from your employer. Simple stands for “Savings Incentive Match Plan for Employees”; employers must either match employee contributions up to 3% of the employee’s salary, or contribute 2% of an employee’s salary regardless of any contribution from the employee. Employees are always fully vested—they can keep the employer’s contributions whenever they leave the company. Employees can contribute up to $14,000 from their salary in 2022, or $17,000 if they’re over 50.
Solo 401(k) pros:
Solo 401(k) cons:
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 $20,500 in 2022 or $27,000 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. 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 ($61,000 if 50 or under/$67,500 if older).
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.