With so many different retirement plan options available, making the right choice for your future can feel like a daunting task. While there are many nuanced differences between plans, a few key concepts will likely drive your decisions.
The first concept to understand is the difference between pre-tax and after-tax contributions. With pre-tax contributions you can deduct that year’s contributions from your income, giving you an up-front tax break. However, you’ll pay income taxes when you make withdrawals. With after-tax contributions, you pay income taxes on your contributions up-front, but that money is never taxed again. Whether you should choose a pre-tax or after-tax vehicle will depend on your tax situation now and what you believe your tax situation will be during retirement.
Required Minimum Distributions, or RMDs, refer to a mandated distribution from your retirement account beginning at a predetermined age. If your retirement plan has RMDs, you’ll be forced to start taking distributions at a certain age regardless of whether you need them or not. Currently, RMDs must begin starting at age 72.
Many retirement plans have different rules depending on your income. Some plans are only available to individuals whose income is below a certain level, while other plans offer potential tax benefits based on income. Most retirement plans also have annual contribution limits.
Now that we’ve covered the big concepts, let’s dive into the different types of plans.
A 401(k) is a workplace retirement account offered as a benefit by employers. Contributions can be made through automatic payroll deductions, making it easy to stick to a savings plan. Contributions to a 401(k) are pre-tax, meaning investments can grow tax-deferred until you begin withdrawals in retirement, at which point any distributions are taxed as income. Early withdrawals – which is generally defined as any withdrawal before age 59 ½ – are subject to an additional 10% tax penalty.
Some employers offer 401(k) matching as a benefit, where the employer will match your contributions up to a certain amount. This is effectively free money, and contributing up to your employer match limit should be a high priority when making decisions regarding your savings plan. The 2021 contribution limits for 401(k)s are $19,600 (or $26,000 if you’re over 50).
One common downside to 401(k)s is their lack of flexibility. Depending on your plan, investment choices may be limited and there can be significant management and administration fees. You often have far fewer investment options with a 401(k) when compared with other vehicles such as an IRA.
Individual Retirement Accounts, or IRAs, are tax-favored investment accounts not linked to an employer. This means you make all the investment decisions, or hire a professional of your choice to assist you. IRAs are a popular choice for people who don’t have a 401K option through their employer, or who have maxed out their 401K contributions and wish to save more. Like 401Ks, distributions are taxed as income during retirement. IRA contributions may or may not be tax-deductible, depending on your income and whether or not you’re covered by a retirement plan through your employer.
IRAs have a much lower contribution limit – $6,000 for 2021 (or $7,000 for those 50 and older). Withdrawals before age 59 ½ are also subject to an additional 10% tax penalty.
Roth IRAs are like traditional IRAs except contributions are made with after-tax dollars. This means you’ll pay income taxes on money contributed to a Roth IRA up-front, but you won’t have to pay taxes on your withdrawals. Early withdrawals are not subject to a tax penalty like in a traditional retirement account, provided five years has passed since your first contribution. Roth IRAs have the same contribution limits as traditional IRAs, though their income limits are much higher. There are currently no RMDs for Roth IRAs.
A Roth 401(k) combines the benefits of a Roth IRA and traditional 401(k), and is beginning to be offered by some employers. Contributions are made after-tax, and there are no income limits for Roth 401(k)s.
Other Common Plans
Savings Incentive Match for Employees IRA, or SIMPLE IRA, is a retirement plan that can be offered by small businesses with 100 or fewer employees. It works similar to a 401(k). Another common retirement plan is the Simplified Employee Pension, or SEP IRA, which is an option for self-employed people with no employees. Contribution limits for SEP IRAs are much higher than other retirement accounts. In 2021 that means $58,000 or 25% of income (whichever is less).
The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.
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