Imagining your retirement can be exciting, but for many, building your nest egg can also be overwhelming.
There are numerous types of retirement plans for individuals. Choosing which one to use may leave you unsure of the best option. The best way to feel confident about your retirement savings is by having a long-term financial plan and a fiduciary financial professional on your team.
In this article, I’ll give a primer on the most common retirement account types, how they work, and who they might work best for.
Selecting the right savings vehicle is not always straightforward. Many factors come into play when you are building a retirement plan: your current age, income level and ideal tax-optimization strategy. Here are some common retirement plans and criteria to consider.
Tip: Free personal finance tools can help you analyze your retirement plan. A good place to start is with Personal Capital’s Retirement Planner, which will help you assess your retirement readiness and identify areas for improvement.
1. Traditional 401k
One of the most popular and widely known investment tools, the 401k, is an employer-sponsored retirement plan that lets you save for retirement in a tax-sheltered manner.
Read More: What is a 401k? – A Comprehensive Guide
Traditional 401k contributions are made with pre-tax dollars, ultimately reducing your taxable income and allowing your contributions to grow tax-deferred until you withdraw your money in retirement.
In 2022, the contribution limit is $20,500 ($22,500 in 2023), and individuals aged 50 and over may contribute up to an additional catch-up amount of $6,500 ($7,500 in 2023).
Employers may offer a profit-sharing or employer match program where they contribute a certain percentage into your 401k plan. Employers can utilize different vesting requirements, such as being employed for a certain number of years. Other time, contributions made on behalf of your employer may be 100% immediately vested, meaning that money is in your own hands once applied to your 401k account. If an employer requires a certain amount or percentage of your salary to be contributed to your 401k in order to receive the matching benefit, you should contribute at least that amount to take full advantage of your employer’s contribution.
Before withdrawing contributions from your 401k, you should work with your financial advisor to avoid paying withdrawal penalties. If you are age 59½ or younger, withdrawals are assessed at a 10% penalty in addition to ordinary income taxes (taxed at your highest marginal tax rate). Though there are a few IRS exceptions from the early withdrawal penalty, taking money out of your 401k before you are 59½ or at the age of 72 (for Required Minimum Distributions) is usually not advised.
Ideal For: If you think you will be in a lower marginal tax bracket when you start withdrawing funds in retirement, a traditional 401k plan can be advantageous.
2. Roth 401k
In addition to a traditional 401k plan, some employers may also offer a Roth 401k option for employees. In contrast to traditional 401k plans, Roth 401k contributions are made with after-tax dollars, providing tax-deferred growth, and fully tax-free withdrawals someday as long as you follow the rules.
Similar to traditional 401k options, Roth 401k users can contribute up to $20,500 in 2022, and individuals aged 50 and over may contribute up to an additional $6,500.
Individuals withdrawing from their Roth 401k prior to turning 59½ may be subject to a 10% withdrawal penalty on a portion of the withdrawn amount. Unlike with a Roth IRA, Required Minimum Distributions (RMD) are mandated with a Roth 401k starting at age 72.
Ideal For: Since Roth 401k accounts are funded using after-tax dollars, these retirement accounts are ideal for individuals who believe they are in a lower tax bracket now than they will be in the future. By using a Roth 401k account, individuals age 59½ or older will not have to worry about paying taxes on their withdrawals and can continue to grow their account tax-free. Additionally, you can avoid RMDs by rolling the plan into a Roth IRA when you reach age 59½ or are no longer working for the employer. This can make Roth accounts an effective legacy planning tool.
3. Traditional IRA
Have you maxed out your 401k contributions? Does your employer not provide a 401k plan or matching program? If this is the case, then an Individual Retirement Account (IRAs) may be an ideal option for you and your retirement goals.
Traditional IRAs are retirement accounts that you open (not through an employer) and fund yourself with eligible earned income.
Even if you contribute to your employer-sponsored 401k plan, you can also contribute to an IRA. However, you’ll want to be aware of the income limits for deducting contributions.
Individuals can contribute up to $6,000 in 2022 ($7,000 if you are age 50 or older) and $6,500 in 2023 ($7,500 for 50 and older).
You may be able to deduct all or a part of your contributions depending on your income level.
For joint filers, if neither spouse is covered by an employer sponsored retirement plan, contributions can receive a full deduction up to the contribution limit no matter the amount of your income.
If you file as a single or head of household and you are covered by an employer-sponsored retirement plan, you can deduct up to the contribution limit if your Modified Adjusted Gross Income (MAGI) is $73,000 or less for 2023. You can take a partial deduction if your income is between $73,000 and $83,000 in 2023. There’s no deduction for single filers who report a MAGI more than $83,000 in 2022.
If you’re married or a qualified widow(er), filing jointly, and are covered by an employer-sponsored retirement plan, you can deduct the full amount if your MAGI is $116,000 or less in 2023. You can take a partial deduction if your income is between $116,000 and $136,000 in 2023. There’s no deduction if you earn more than $136,000 in 2023.
If married filing separately, you can qualify for a partial deduction if your MAGI is less than $10,000.
All withdrawals from a traditional IRA will generally be taxed at federal and state ordinary income rates. Similar to traditional 401ks, a 10% penalty will be applied on any withdrawals before age 59½. Some exceptions may apply so consult with your financial advisor before withdrawing from your IRA.
Ideal For: Traditional IRAs may be best for those who have maxed out their 401k plans or do not have access to employer-sponsored retirement plans. An added benefit of IRAs is the potential to have more investing options such as individual stocks and ETFs. Meanwhile, 401k plans may be limited to a certain number of preselected funds.
4. Roth IRA
Different from traditional IRAs, Roth IRAs offer tax-deferred growth and no taxes on withdrawals under the right circumstances. Roth IRA contributions cannot be deducted from your income taxes.
You can contribute to a Roth IRA even if you already own a 401k plan or traditional IRA. It is important to know that if you contribute to both a traditional and Roth IRA, the yearly contribution limit applies collectively to both, so the total amount of contributions cannot exceed the contribution limit.
Here are the limits to contributions you can make in 2023.
Single tax filers who have a 2023 MAGI below $138,000 will be able to contribute up to the maximum amount of $6,500 (increases to $7,500 if you are age 50 or older). The contribution limit begins to phase out for single filers who report MAGI levels between $138,000 and $153,000, while those who report more than $153,000 for their MAGI will not be eligible for a Roth IRA contribution.
For those married and filing jointly, if your 2023 MAGI is below $218,000, you can contribute up to the yearly maximum of $6,500. For those age 50 or older, that maximum yearly amount increases to $7,500. The contribution limit to a Roth IRA begins to phase out and decreases for married households that have a MAGI between $218,000 and $228,000. Those who report more than $228,000 in MAGI are ineligible to contribute to a Roth IRA.
Married couples that file separately and report MAGI levels exceeding $10,000 will not be eligible to contribute to a Roth IRA. Those who report a MAGI below $10,000 will be able to contribute at a reduced level.
Tax filers that report as head of household or married filing separately, but have not lived with their spouse in the past year, will be able to follow the limits and rules for single filers.
If you have an existing 401k plan or traditional IRA and would like to move those funds into a Roth IRA, you can complete what is called a Roth conversion. It’s important to note that conversions from other retirement accounts have no impact on your 2023 contribution limit, but may increase your total MAGI and therefore trigger a phaseout of your Roth IRA contribution amount. Individuals who are not eligible for Roth contributions due to income limitations are generally still eligible to convert dollars from traditional retirement plans. Talk with an accountant or tax specialist to see if this makes sense for your financial plan.
Ideal For: Roth IRAs will allow your retirement savings to grow and be withdrawn tax-free in the future. Roth IRAs can also be left alone as there are no required minimum distributions (RMDs) until inherited, so they can be left as an inheritance or future nest egg to tap into. Roth accounts are generally good investment tools for people who believe their tax bracket in retirement will be higher than it is now. If you think you’ll be taxed higher in retirement, then it’s better to pay the taxes now.
5. SEP IRA
SEP IRAs (Simplified Employee Pension) are another retirement tool that could help you reach your retirement goals. SEP IRAs are profit-sharing plans that allow business owners to contribute to both their employees’ retirement savings and their own. A SEP IRA allows employers to make tax-deductible contributions on behalf of their employees.
A SEP IRA must include all employees who are at least 21 years of age, have worked for the employer in 3 of the last 5 years, and received at least $600 in compensation from your business for the year, though some plans have less restrictive eligibility requirements.
It’s possible for SEP IRA contribution limits to be higher than traditional IRA limits. In 2023, contributions cannot exceed the lesser of 25% of eligible compensation or $66,000. It is important to note that contributions must be made in cash and not in property.
SEP IRAs have several contribution rules and guidelines to keep in mind, so discuss these with a financial planner or visit the IRS guidelines page.
Ideal For: Many small business owners don’t employ enough people to justify the cost of a full 401k, so a SEP IRA is a great benefit to offer in a small business setting due to its minimal administration costs.
6. SIMPLE IRA
SIMPLE IRAs (Savings Incentive Match Plan for Employees) are another option available to small business owners. These were created as a solution for small employers who do not currently sponsor a retirement plan, are relatively easy to establish, and available to any small business with fewer than 100 employees. It is important to remember that the employer cannot have any other retirement plan if they are setting up a SIMPLE IRA.
Similar to an employer-sponsored 401k, SIMPLE IRAs allow employees to contribute to the plan via salary deferrals.
In 2023, the deferral limit for a SIMPLE IRA is $15,500.
Employers are generally required to contribute each year a matching contribution up to 3% of compensation or 2% non-elective contribution for each eligible employee, based on a maximum eligible compensation amount of $330,000 in 2023.
Eligible employees include those who earned at least $5,000 in compensation during any 2 years before the current calendar year and expect to receive at least $5,000 during the current calendar year. Early withdrawal from retirement accounts should be carefully considered with a financial planner as special penalties can apply to SIMPLE IRAs.
Ideal For: SIMPLE IRAs are suited as a start-up retirement savings plan for small employers (less than 100 employees) that are not sponsoring another retirement plan. Start-up and administrative costs that traditional retirement savings plans have are usually low with a SIMPLE IRA. There are also no filing requirements associated with a SIMPLE IRA so the plan is simpler to maintain than some other traditional retirement savings vehicles.
7. Self-Directed IRA
Self-Directed IRAs are similar to traditional and Roth IRA options in that they fall under similar eligibility requirements and contribution guidelines. The main difference is Self-Directed IRAs allow investors to own assets such as real estate, gold, and privately-held securities.
In order to create a Self-Directed IRA, an investor must work with a trustee or custodian who specializes in the less typical types of investments you’re interested in holding in the account.
It is important to know the IRS forbids certain investments like collectibles and life insurance.
Ideal For: Due to the complex rules, high fees, and potential for serious issues inherent in self-directed IRAs, traditional or Roth IRAs are often simpler solutions for achieving your retirement planning goals.
Similar to 401k plans, 457 plans are offered by state and local governments and nonprofits. 457 plans are also funded with payroll deductions, meaning the employee will receive tax-deferred growth until withdrawals are made.
In 2023, the contribution limit for 457 plans is $22,500. For employees age 50 or older, the contribution limit can include an extra catch-up provision of $7,500.
A key difference for 457 plans is early withdrawals before age 59½ are not subject to penalties, but are still subject to federal and state ordinary income tax rates.
Some 457 plans may also allow participants who are nearing retirement to compensate for years in which they did not contribute to the plan but were eligible to do so. The IRS includes additional details on 457 plans, but it should be advised to seek advice from the plan administrator for contribution and withdrawal guidelines.
403(b) plans are retirement plans for certain employees of public schools and certain 501(c) tax-exempt organizations. 403(b) plans enable employees to contribute some of their salary to the tax-deferred plan, as the employer may also contribute to the plan for employees.
Eligible employees for 403(b) plans include those who work for public schools, state colleges and universities, churches, and certain ministries.
Like traditional 401ks, 457s, or IRAs, 403(b) retirement plans allow employees to contribute retirement savings that will not be taxed until the funds are withdrawn from the plan.
Some 403(b) or 457 plans offer a Roth contribution option as well.
Tip: Personal Capital now offers retirement plan advisors as part of our holistic wealth management services.
Considerations for Choosing a Retirement Plan in 2023
As you can see, there are options for retirement savings vehicles. Depending on your employer’s offerings, income level and tax-optimization goals, we recommend working with a financial advisor to help determine your ideal investment tools so you can start saving for the retirement you want.
Here are a few suggestions for you:
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