The days of workers relying on Social Security and an employee pension plan to fund their expenses during their retirement years are long gone. Pensions are already uncommon, and the future viability of Social Security is not guaranteed.
Uncle Sam offers tax benefits on retirement accounts because he wants you to invest for your future. To help you navigate your options, here’s a comparison of six of the most common types of retirement plans:
The 6 Most Common Types of Retirement Accounts
| 401(k) | Traditional IRA | Roth IRA | SEP IRA | Simple IRA and Simple 401(k) | Solo 401(k) | |
|---|---|---|---|---|---|---|
| Best for | Employees who anticipate retiring into a reduced marginal tax bracket. | People who work for themselves and don’t have access to a 401(k) or similar workplace retirement plan. | For those currently paying taxes at a lower rate than they anticipate when they retire. | Self-employed individuals; are business owners who employ one or more people. | Self-employed people; businesses with up to 100 employees | Self-employed people only have their spouse as an employee. |
| Funded by | Employee deferrals; employer contributions | Individual contribution | Regular contributions; Spousal IRA contributions; Transfers; Rollover contributions | Employer; individual, if self-employed | Employee deferrals; employer contributions | Self or qualified spouse |
| 2022-2023 employee contribution limits | The employee 401(k) contribution cap for 2023 is $22,500 for 2022, it is $20,500. A catch-up payment of an additional $6,500 for 2022 and $7,500 for 2023 is available to anyone 50 or older. | For people under 50 and those over 50, the total annual contribution limit for a regular IRA in 2022 is $6,000 and $7,000, respectively (since the latter are eligible for catch-up contributions). In 2023, these ceilings will rise to $6,500 for everyone under 50 and $7,500 for everyone else. | The pretax maximum for regular 401(k) plans is the same for 2022 and 2023 as far as Roth 401(k) contribution caps are concerned. | Employer (or sole proprietor) contributions for workers are only allowed to be up to 25% of net self- employment income, or a maximum of $61,000 in 2022 and $66,000 in 2023. | $14,000 for those under age 50 in 2022 and $15,500 in 2023. 50 and older individuals can make a catch-up payment of an additional $3,500 in 2023 and $3,000 in 2022. | Less than the lesser of $20,500 in 2022, $22,500 in 2023 (or $27,00 and $30,000 for individuals over 50), and 100% of earned income |
| 2022-2023 employer contribution limits | For 2022, the overall cap on employer and employee contributions is $61,000 ($67,500 with catch-up), and for 2023, it is $66,000 ($73,500 with catch-up). | The only person who can contribute to a traditional IRA is the individual. | The pretax maximum for conventional 401(k) plans is the same as the Roth 401(k) contribution limits for 2022 and 2023. | $61,000 in 2022 and $66,000 in 2023, or up to 25% of salary. | Either a fixed contribution of 2% or a required matching payment of up to 3% of an employee’s salary | As both an employer and an employee, you are eligible for up to $61,000 in 2022 and $66,000 in 2023. The increased contributions for people over 50 are $73,500 in 2023 and $67,500 in 2022. |
| Taxes on contributions and earnings | Until you decide to take a distribution, the money in your 401(k) grows tax-free. After that, you’ll have to pay income tax on the money you take out. | For some investors, contributions to a traditional IRA may be tax deductible. | Only after-tax contributions are accepted for Roth IRAs, but after five years and reaching the age of 59 1/2, you can withdraw your funds without paying taxes. | Earnings grow tax-deferred while contributions and investment income are tax-deferred. | Earnings grow tax-deferred, while contributions and investment income are tax-deferred. | Traditional Solo 401(k) contributions and investment income are tax-deferred; Solo Roth 401(k) contributions are taxed; profits increase tax-free. |
The Key Differences Between The 6 Retirement Accounts
These retirement plans are different from each other in many ways, but most importantly in the following aspects:
Tax advantages: some plans have tax advantages when you invest money into the plan, while others are when you withdraw the money
Contribution limits: the maximum amount you can put in each account also vary every year
Withdrawal rules: you can withdraw money from the plan with no penalty and applicable penalties for non-compliant withdrawals.
The Pros and Cons Of Each Retirement Account
401(k): The ‘Standard’ Employee Retirement Plan
Since employers typically work to make them simple to set up and manage, your 401(k) retirement plan offered by your employer may be a very practical option if you’re an employee. A 401(k) retirement plan is frequently provided to employees by for-profit businesses. In most cases, you can contribute by simply directing a portion of your salary to the 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 to fully own your employer’s matching contributions.
Other benefits that come with 401(k) are;
Tax-free growth. Until you decide to take a distribution, the money in your 401(k) grows tax-free. After that, you’ll have to pay income tax on the money you take out. Like most other retirement plans, you must be 5912 years old or older to withdraw money without incurring penalties, and you can begin doing so at age 72.
Contribution matching. Many businesses match your contributions to 401(k) plans, which makes them quite appealing. That may be free money. The drawback is that you can only accrue employer contributions over several years (known as “vesting”). You will keep all of your contributions but may only receive a portion of your employer’s contributions if you quit the company before becoming “fully vested” You can “rollover” your contributions to another company’s 401(k) plan or another form of a retirement plan if you change employers or retire.
High contribution thresholds. The relatively high contribution cap for 401(k) plans, which is $20,500 in 2022 or $27,000 if you’re 50 or older, is another draw. The maximum contribution is $61,000 (or $67,500 for those over 50), including employer and employee contributions.
Limited options for investments. The fact that there are typically only a few investment options available inside 401(k) plans, such as mutual funds, is a drawback.
Traditional IRA: A Retirement Plan for Anyone
Individual Retirement Arrangement is referred to as an IRA. Traditional IRAs are tax-favored savings accounts that people typically open and administer. A regular IRA may be intriguing if you need access to a 401(k) plan through your work because almost anybody with taxable income can contribute to one (k).
Traditional IRA pros:
- Available to anyone
- Many plan and investment choices
Traditional IRA cons:
- Low contribution limits
- Required minimum withdrawals starting at age 73
Other benefits that come with traditional IRA are
Tax advantages. Traditional IRAs and 401(k)s are comparable in many ways, including how tax advantages operate. Your contributions lower your taxable income, the investment grows tax-free until you remove it, and both contributions and withdrawals are subject to the same age limits.
Lower contribution limits. The maximum contributions are significantly reduced to $6,000 in 2022 or $7,000 if you’re 50 or older. On the other hand, you can pick from various IRAs offered by various financial services firms, and each plan might offer a far wider selection of investment choices, such as stocks and mutual funds.
You can fund an IRA and a 401(k) in some circumstances, but be cautious because your IRA contributions might not be tax deductible unless your income is below a certain threshold.
Roth IRA: A Different Retirement Plan Tax Advantage
The main distinction between a Roth IRA and a standard IRA is when you receive the tax benefits. When you contribute to a typical IRA, you don’t pay income tax; but you do when you withdraw the funds. The exact opposite is true of a Roth IRA: you pay taxes on the money you contribute but can withdraw it tax-free in retirement, meaning that every dollar in your account is money you keep.
Roth IRA pros:
- Has 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
What to choose between Traditional or Roth IRA
According to experts, whether you anticipate paying more or less in taxes after you retire is a key consideration. Since their income will be smaller after retirement, many people anticipate a lower tax rate. If you fall into one of these categories, a traditional IRA would be a better option; if not, a Roth IRA might result in lower income tax payments.
A Roth IRA and a regular IRA differ in additional ways. For instance, you are not required to begin withdrawals at age 72 and are permitted to make some early withdrawals without incurring penalties (although there are restrictions).
A Roth IRA can only be funded if your income is below a certain level, unlike a standard IRA. Roth IRAs are similar to standard IRAs in other ways, such as contribution limits.
SEP IRA: For Self-Employed or Small Business Owners
Although legally, it can be utilized by any size firm, a SEP IRA is a particular sort of IRA that self-employed individuals or small business owners typically use. SEP stands for simplified employee pension. These retirement programs can be simpler and less expensive for companies than conventional 401(k) plans.
SEP IRA pros:
- Higher contribution limits
- Immediate vesting can be an advantage for employees
SEP IRA cons:
- Immediate employee vesting may be a disadvantage for employees.
Another advantage that comes with SEP IRA is;
Bigger retirement savings. A SEP IRA has the advantage of allowing for substantially larger annual retirement deposits than a conventional IRA. An employer may contribute up to 25% of each employee’s income, up to $61,000, in 2022.
If you work for yourself, you may contribute up to 25% of your net income, subject to the same cap. Employees are always immediately 100% vested in company contributions, unlike with a 401(k), which may be advantageous for employees or disadvantageous for employers looking to retain the best talent.
Simple IRA: A Simpler Small Business Retirement Plan
For small organizations with 100 or fewer employees, a simple IRA is an additional type of employee retirement plan. You will typically get contributions from your company if you are an employee and participate in the Simple IRA offered by your employer.
Simple IRA pros:
- Has an easy process to set up
- Contributions are matched or guaranteed for employees.
Simple IRA cons:
- Contribution limits are lower than SEP IRAs or 401(k) plans.
Simple, which stands for “Savings Incentive Match Plan for Employees,” mandates that companies either match employee contributions up to 3% of the employee’s salary or make a 2% contribution regardless of whether the employee contributes.
The employer’s contributions are always completely vested in the employee, who is entitled to keep them whenever they leave the company. In 2022, employees can make salary contributions of up to $14,000 or $17,000 if they are over 50.
Solo 401(k): For Business Owners with No Employees
Solo 401(k) plans, often called solo or one-participant 401(k) plans, can enable self-employed people and business owners who need more staff to optimize their retirement savings. They operate similarly to standard 401(k) plans, except that company and employee contributions can be used to increase savings.
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
- It may be more complicated to set up than IRAs
As an employee, you may deduct up to $20,500 in 2022 or $27,000 if you are 50 years of age or older from your self-employment income. Then you can assume the role of employer and contribute up to 25% of your company’s revenue.
Although the maximum contribution limits are the same ($61,000 if 50 or under/$ 67,500 if older), this dual contribution formula may allow you to contribute more than with other retirement plans, such as SEP IRAs, depending on your income level.
Bottomline
You need to be proactive to reach your retirement goals. The earlier you begin retirement planning, the better off your retirement will be in the long run. There are dozens of ways to help you maximize the next 25 years or more of your life if you are close to retiring.
All retirement plans offer tax benefits as a motivator to save for retirement. Different retirement plans have different withdrawal restrictions, contribution caps, and when income tax is due. But due to their numerous variables, any person may or may not be qualified for the tax benefits of these programs. As a result, you need to talk to a qualified tax advisor about your situation.
To better help you in planning your finances as you reach your golden years, our Guide To Finance For Seniors can get you started on the right track by giving you a concise overview of what you need to focus on, where you can get help, or what to prepare for.
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