Unless you’re a financial professional, you’ve probably found yourself confused at times about various types of retirement plans. You’re not alone. It can be difficult to recall the difference between a Traditional IRA and a Roth IRA, or explain the tax implications of a Traditional 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 away into your 401(k) or other defined contribution plan, or perhaps sometimes you make an IRA contribution; but how often do you really consider the basic features of such plans?
The clock to your retirement is running down and knowing more about the retirement plans available to you could help you save more effectively. So, let’s spend a few minutes going over some of the basic types of retirement plans and their tax benefits,1 contribution levels and other defining features.
Over the years, the federal government has created a number of different accounts designed to help you save for retirement, some of the most popular of which we detail below. How accessible or appropriate each is for your particular circumstances will vary, but knowing how they all work can be helpful as you consider your options.
Participating in a 401(k) plan is the first way many Americans begin to save for retirement. With these plans, you contribute money deducted from your paycheck and generally (but not always) also get a matching contribution from your employer.
In traditional 401(k) plans these deductions occur before taxes are calculated, meaning you actually owe less to the IRS by contributing to them. 401(k) plans also shield your investments from taxes on trading and growth in the account. Instead, you pay taxes on your eventual withdrawals, which are treated as ordinary income. This is why 401(k)s and similar types of retirement plans are often called “tax advantaged” or “tax deferred.” Here’s how it works:
The first two provisions are pretty self-explanatory, but the RMD is worth a closer look. Here’s how it works: To prevent you from hoarding retirement savings, the IRS requires you to annually withdraw a certain percent of your assets from tax-deferred accounts once you pass age 70 ½, so the money can be taxed. Otherwise, you get penalized. In that sense, there’s no “free lunch” from the IRS, even with a tax-deferred retirement plan like a traditional IRA.
Another important note: 401(k) plans often come with a so-called “vesting period.” If your company matches your contributions, the vesting period determines when their matching contributions actually become yours. Usually, this requires you to stay with the company for a certain period of time. If you leave before you are “fully vested,” the company might take back some or all of the matching funds and a relative percentage of your gains or losses. This is essential information you should know if you work at a company with a 401(k) plan and have thoughts about moving on. Many companies spell out the rules, including vesting schedules, for their 401(k) plans on their employee website or in employee handbooks, so check those out when you start contributing to avoid any unpleasant surprises later.
Other rules for 401(k) retirement plans include (as of 20182):
While a 401(k) is an employer-sponsored plan for all of the organization’s employees, an Individual Retirement Arrangement (IRA) is set up by you—the individual. They are also used to hold investments that “roll over” from 401(k)s and other types of retirement plans when you leave your employer, so you can continue to easily manage all your securities. Though you are most likely to be the person to create your IRA and be its sole contributor, some specific types (SIMPLE and SEP) are employer-sponsored and may receive employer contributions.
Traditional IRAs are tax deferred in a similar way to 401(k)s, allowing you to deduct contributions from your taxable income (within contribution limits set by the IRS that phase out for high-income earners). Again, this can reduce current tax burdens while at the same time shielding money within the account from taxes while it grows. Taxes are paid once the funds are withdrawn, as ordinary income.
The withdrawal restrictions are also similar to a 401(k), though with a few key differences. First, penalty-free withdrawals can only be taken after 59½, not 55, regardless of your work status (though Public Safety Officers can still access these at 50 from a 401(k)). Additionally, while you can take a penalty-free loan from a 401(k) and some other defined-contribution plans for numerous reasons, IRAs only allow withdrawals for a limited range of “hardship” events,3 such as paying college tuition, covering medical costs after a job loss or making mortgage payments to prevent a foreclosure.
While you can make unlimited contributions to traditional IRAs up to your annual income, there are limits on the deductions. These rules for deductible IRAs (as of 20184) include:
If you work for a non-profit, specifically a 501(c)(3) company, or a hospital, public school, university, ministry or similar organization, you might have a 403(b) retirement plan. This type of plan is designed specifically for these types of organizations.
A 403(b) operates very much like a 401(k), meaning you make your deposits before the contributions are taxed, and there are no taxes on trading or growth. You face penalties for withdrawal before age 55 and you’re subject to RMD after age 70½.
But 403(b) plans differ in that they generally offer annuities more often than typically seen with IRA or 401(k) retirement plans. Most modern 403(b) plans permit traditional securities investments in products like mutual funds and are increasingly allowing investments in exchange traded funds (ETFs).
As with a 401(k), the 403(b) caps contributions at $18,500 for employees plus any match from the employer, but if you’re 50 or older you can put away an additional $6,000 (plus match) each year (as of 2018). 403(b)s may also allow an additional catch-up contribution of up to $3,000 annually for employees who have worked for an organization for 15 years (at the discretion of the plan’s sponsor).8
Any of the above-three retirement plans can also be structured in an alternative style, called a Roth account (Roth 401(k), Roth 403(b), Roth IRA). The key difference with contributions to a Roth account is the money is taxed up front—you pay ordinary income tax on the contribution before you put the money in. Then, when you are eligible to take the money without penalty, you pay no taxes.
If you elect to use a Roth account, your trading and growth still aren’t taxed, but (unlike with traditional retirement plans) neither are your withdrawals after retirement age.
Though you still get penalized for early withdrawal of earnings beyond your contributions before age 59½, with a Roth IRA there are no RMDs. Remember, though, that Roth 401(k) plans do fall under the RMD rules but allow for earlier withdrawals. To prevent having to take distributions from them, remember to roll these plan assets into a Roth IRA.
Also, keep in mind that contribution limits apply to all accounts of a particular type. Contributions to a Roth IRA account will count against how much can be saved in its related traditional IRA account, and vice versa. Another note: Employer matches in 401(k), 403(b) and similar defined-contribution plans can only go to into the traditional accounts of these plans (because, technically, you haven’t been given the money yet to pay taxes on it).
Now that you have a basic introduction to the different types of retirement plans, you might be wondering which one is right for you. The fact is, your individual circumstances will likely determine which accounts you can invest in. While most people can find a bank or brokerage firm willing to offer an IRA with an affordable minimum balance, individual employers decide what types of sponsored plans their employees can invest in. Given how complex the tax burdens can be with these accounts, you might also find it useful to work with a tax professional as well as a financial adviser when planning which accounts to use to maximize your benefits.
However, if there’s one lesson to take away about the different types of retirement plans, it’s that you should almost always try to maximize contributions to retirement plans that see a match first. Think of these matches as an instant return on investment, and it becomes clear you’d need an ultra-high growth rate in another type of retirement account to match that performance. Through the power of compounding, this extra return can significantly increase the long-term potential growth of your account.
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 financial-planning services designed to help qualified investors9 create a clear path to their retirement goals. Please contact us or download any of our free retirement guides for more information.
1 The contents of this document should not be construed as tax advice. Please contact your tax professional.
2 Source: 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.
3 Source: Internal Revenue Service, Retirement Topics - Hardship Distributions, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-hardship-distributions
4 Source: Internal Revenue Service, Retirement Topics - IRA Contribution Limits, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
5 Source: Internal Revenue Service, 2018 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/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work
7 Source: Internal Revenue Service, 2018 IRA Contribution and Deduction Limits - Effect of Modified AGI on Deductible Contributions if You are NOT Covered by a Retirement Plan at Work, https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-not-covered-by-a-retirement-plan-at-work
8 Source: Internal Revenue Service, Retirement Topics - 403(b) Contribution Limits, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-403b-contribution-limits.
9 Fisher Investments requires a minimum $500,000 investment.