Basic Retirement Account Types
It can be difficult to recall the differences between a traditional IRA and a 401(k). It’s easy to go months, or even years, without really thinking about the different types of retirement plans out there. With each paycheck, you may funnel a little money into your plan, or perhaps sometimes you make an IRA contribution. But how often do you really consider the basic features of such plans? Below you’ll find some basic information about common retirement accounts, including a quick overview of their tax benefits, contribution levels and other defining features.1
Defined Contribution Plans
Participating in a 401(k) plan or other employer-sponsored defined contribution plan is a common way that many Americans save for retirement. With these plans, you contribute money deducted from each paycheck. Some employers even offer a matching contribution or a profit-sharing contribution on top of the money you contribute.
Contributions to traditional defined contribution plans are often called tax advantaged or tax deferred. That means that neither you nor your employer pays tax on contributions or accumulating growth. However, you’ll pay income tax when you withdraw the funds. Roth-type defined-contribution plans are the major exception, which we’ll describe later.
Defined Contribution Plan Contribution Limits (as of 2023)2
Contribution limits are the same for many employer-sponsored defined contribution plans, but you may have special circumstances increase or decrease your contribution limits. Most employer-sponsored retirement plan administrators should automatically stop your contributions once you’ve reached the plan’s contribution limit for the year; however, the limits are still useful to know.
- The general limit is an annual contribution cap of $22,500 in 2023 for employees (plus any match from their employer).
- Employees age 50 and older are allowed to put in an additional $7,500 per year in tax-deferred contributions for 2023, plus their company’s match.
- Your employer’s contributions can combine with yours for no more than $66,000 per year, depending on the plan’s provisions.
- If you are over age 50, the combined contribution cap between you and your employer for applicable plans increases to $73,500.
These limits are constantly changing because of new retirement legislation passed by Congress or annual adjustments made by the Internal Revenue Service (IRS). If you have questions about your contribution limits, we recommend contacting your plan administrator or consulting the IRS website for the latest figures.
Defined Contribution Plan Withdrawal and Distribution Restrictions3
Generally speaking, employer-sponsored defined contribution plans are meant for retirement savings; therefore, there are some restrictions on when you are able to withdraw funds. If you take money out before a certain age, or if the withdrawal isn’t for a distributable event specified by the plan, you may be subject to penalties.
- You may pay a penalty for withdrawing funds before you turn 59½. This can be as early as age 55 if your employment is terminated by the sponsoring employer, or as early as 50 for public safety officers.
- If you are terminated by your employer after age 55 and haven’t turned 59½, you can take penalty-free withdrawals from your current plan.
- Under current law, you are most likely subject to required minimum distributions (RMDs) after you turn age 73, unless you are still working and do not own more than 5% of the business for which you work.
- Distributable events vary for different types of plans, and for different types of contributions or accounts within those plans. The plan is not required to allow distributions for every possible distributable event. We recommend you consult your summary plan description or other disclosure documents to understand your specific allowable circumstances for distributions.
Required Minimum Distributions (RMDs)4
If you turned 73 after December 31, 2002, the IRS requires you to withdraw a certain percent of your assets from tax-deferred accounts each year, so the money can be taxed. This is known as a required minimum distribution (RMD). If you fail to withdraw your RMD amount, you will likely face penalties. Even with tax-deferred retirement plans, you must pay taxes at some point. In 2033 , the age for RMDs is scheduled to increase again to 75.
Vesting Periods
Employer-sponsored retirement plans often come with a vesting period. If your company matches your contributions, the vesting period determines when their matching contributions actually become yours. Usually, this requires you to maintain active employment with the company for a predetermined length of time. If you leave before vesting period is over, the company might take back some or all of the matching funds and a relative percentage of your gains or losses. Many companies spell out the rules, including vesting schedules, for their retirement plans on their employee website or in employee handbooks, so it’s advisable to review those when you start contributing to avoid any unpleasant surprises later.
Traditional IRAs
Unlike employer-sponsored retirement plans, an individual retirement account (IRA) is set up by you—the individual. Traditional IRAs are tax-deferred retirement accounts, so taxes are paid as ordinary income once the funds and earnings are withdrawn. Traditional IRAs can also be used to hold investments that “roll over” from 401(k)s and other tax-deferred defined contribution plans when you leave your employer.
Contributions to IRAs are sometimes tax deductible, but there are limits set by the IRS. You may not be able to deduct contributions once your annual income exceeds a certain threshold. Deducting IRA contributions can reduce current tax burdens, while at the same time shielding money within the account from taxes as it grows.
Traditional IRA Contribution Limits (as of 2023)5
While there is no income limit for contributing to a traditional IRA, there are income limits for what contributions can be considered tax deductible.
- If you are under age 50, the annual contribution limit is $6,500.
- The annual IRA contribution limit is $7,500 for those 50 and older.
- The IRA contribution limit does not apply to rollover contributions.
- Under some conditions, the IRS also allows certain military reserve members who aren’t on active duty (qualified reservists) to repay account distributions, even if the repayment exceeds the annual contribution limit.
- Depending on your adjusted gross income (AGI) and filing status with the IRS, you may have stricter tax-deductibility caps.6 We recommend consulting a tax adviser when determining how much you can deduct.
These limits are constantly changing because of new retirement legislation passed by Congress or directives from the IRS. If you have questions about your contribution limits, we recommend consulting the IRS website for the latest figures or contacting a financial professional.
Traditional IRA Withdrawal and Distribution Restrictions 7
There are restrictions on when you can withdraw funds from your IRA that you should pay attention to or it can cost you. In most cases, if you withdraw money before you turn 59½, you are charged a 10% penalty, but there are some exceptions:
- If you are terminated by your employer after age 55 and haven’t yet turned 59½, you can take penalty-free withdrawals from your IRA.
- You can also avoid withdrawal penalties if you use the funds for specific IRS-approved reasons, such as qualified education expenses or some unreimbursed medical expenses.
We recommend consulting a tax adviser if you have questions about penalty-free withdrawals from your IRA penalty free.
Roth Accounts
Roth accounts are another popular retirement account option. The primary difference between Roth and Traditional is when you pay taxes on contributions. You make Roth contributions after you’ve paid taxes, unlike Traditional accounts where contributions haven’t been taxed yet. The money grows tax-free, then, when you are eligible to take the money, you pay no taxes on withdrawals as long as certain criteria are met.
Establishing a Roth IRA should be relatively easy. Most financial institutions that offer traditional IRAs also offer Roth IRAs as well. However, income limits mean that some high earners might not be able to contribute to a Roth IRA. It’s best to seek advice from your financial professional or tax adviser regarding contributions and withdrawals for IRAs.
Some defined contribution plans offer Roth options as well—such as a Roth 401(k) and Roth 403(b). Roth defined contribution plan contribution limits are generally higher than Roth IRA contribution limits, making them a great retirement savings option for people whose employers offer this plan. If you have questions about your retirement plan, please contact your plan administrator. They should be able to provide you with more details on your retirement plan options.
What’s Next?
Now that you have a basic introduction to the different types of retirement plans, you might be wondering which one is right for you. Employer-sponsored plans often benefit from employer-match options and fewer income limitations, while traditional and Roth IRAs might offer more investment options. You might also find it useful to work with a tax professional, financial adviser and your retirement plan administrator to better understand your options.
If you’re still struggling to decide which types of retirement plans provide the best way to save, consider working with Fisher Investments. We offer portfolio management and access to financial-planning services designed to help qualified investors 8 create a clear path to their retirement goals.
Download Any of Our Free Retirement Guides For More Information
1The contents of this document should not be construed as tax advice. Please contact your tax professional.
2Source: Internal Revenue Service, Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
3Source: Internal Revenue Service, When Can a Retirement Plan Distribute Benefits?, https://www.irs.gov/retirement-plans/plan-participant-employee/when-can-a-retirement-plan-distribute-benefits.
4Source: Internal Revenue Service, Retirement Topics — Required Minimum Distributions (RMDs),https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds.
5Source: Internal Revenue Service, Retirement Topics - IRA Contribution Limits, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
6Source: Internal Revenue Service, 2023 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions If You ARE Covered by a Retirement Plan at Work, https://www.irs.gov/retirement-plans/2023-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work.
7Source: Internal Revenue Service, Retirement Topics - Exceptions to Tax on Early Distributions, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions.
8Fisher Investments requires a minimum $500,000 investment.
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