Basic elements of IRAs and workplace plans

11 min read

Tax-advantaged retirement plans come in a wide array of choices, from those that can cover almost anyone to those reserved for specific kinds of employees. The IRA and the 401(k) are the most common, but even these well-regarded plans have multiple versions that provide various benefits, depending on whether you’re an employee, self-employed or an individual.

Below are some of the most common IRAs and workplace retirement plans and the key details that you need to know.

3 types of workplace and retirement plans:

  1. Plans for employees – retirement options usually offered at a job
  2. Plans for individuals – retirement plans regardless of where you work
  3. Plans for small business – retirement plans for the self-employed and small businesses

1. Plans for employees

Retirement plans for employees consist of: the traditional 401(k), the Roth 401(k), the 403(b), and the 457(b).

Traditional 401(k)

A traditional 401(k) is an employer-sponsored plan that has significant tax advantages, letting you take a break on this year’s taxes on any contributions you make and allowing the money to compound tax-deferred until you take it out at retirement. At retirement (age 59 ½ or later) distributions from the plan create a taxable gain. Contributions are limited to $19,500 in 2020, but consumers age 50 and older can make an additional catch-up contribution of $6,500.

Pros: A traditional 401(k) can pull money straight from your paycheck and automatically invest it, so you won’t have to worry about the process. You can often invest in many kinds of high-return investments, including stocks and stock funds. You won’t have to pay taxes on any gains until withdrawal, so you can safely realize gains within the plan. Plus, many employers offer a “matching contribution” that gives you additional money – a guaranteed return – for saving. If you leave your employer, you can roll over your 401(k) to a new employer or into an IRA.

Cons: Like many other tax-advantaged plans, a traditional 401(k) can hit you with a penalty for withdrawing the money before retirement age on top of the taxes that you already owe on the gains. So this drawback makes the plan less flexible. Many 401(k) plans allow you to take a loan from your funds, but that depends on your employer’s plan. Your investment options are limited to the funds offered by your employer’s plan, so you may not get the investment you want and you may pay a higher price than you otherwise could.

What it means for you: A traditional 401(k) is a solid retirement option that offers numerous benefits, and it’s one of the most popular plans in the U.S. If you can get bonus matching funds from your employer, you can turn the plan into a compounding machine.

Roth 401(k)

A Roth 401(k) works similarly to a traditional 401(k), but with a few important twists. With a Roth 401(k), employees contribute money on an after-tax basis, so they don’t enjoy a tax break on current taxes. Instead, they’ll be able to compound any gains in their account tax-free and then withdraw money in retirement (age 59 ½ or older) completely tax-free as well. Contributions are limited to $19,500 in 2020, while those 50 and over can make a catch-up contribution of $6,500.

Pros: Like the traditional 401(k), the Roth 401(k) will pull money straight from your pay and invest it, so that you won’t have to handle that chore. You can often invest in higher-return options such as stocks and stock funds, and you won’t be hit with any taxes on your gains. Many employers also add a matching contribution if you add money to the account, and you can roll over the account to a new employer or to an IRA, if you leave your employer. Plus, you get to withdraw money from the account tax-free, as long as you follow the plan’s rules.

Cons: If you want to take out your money before age 59 ½, you’ll be hit with a 10 percent early withdrawal penalty, as you would be with a traditional 401(k). You may be able to take a loan on your plan, but that depends on whether your employer offers it. Your investment options are limited to what’s available in your plan: You may not be able to buy the fund you want or may pay a higher cost for the funds you are offered. Any matching funds you receive from your employer go into a traditional 401(k) account, so you won’t get the same tax benefits on that money.

What it means for you: Many employees wonder which plan – the traditional 401(k) or the Roth 401(k) – is the better option. That depends on several factors, most importantly your tax bracket and expected future income, but also future tax rates. But the Roth 401(k) is a great pick because of its tax-free withdrawals, and it’s very popular especially for this reason. This Bankrate calculator can also help you run the numbers on the decision.

403(b)

A 403(b) works similarly to a traditional 401(k) plan, but it’s offered to employees of public schools, churches and some charities, among others. Employees contribute pre-tax money, so they get a tax break today on contributions, and they’ll enjoy tax-deferred growth on their investments. Withdrawals at retirement (age 59 ½) become a taxable gain. Contributions are limited to $19,500 in 2020, while those 50 and above can make a catch-up contribution of $6,500.

Pros: With a 403(b), you can set up payroll deduction so that you can have your contributions invested directly into your investments. You can typically invest in a range of options, including stocks and stock funds as well as annuities. Any gains in the account are tax-deferred, and you’ll owe taxes only when you withdraw money. Employers may offer you a matching contribution for saving money in your 403(b) account.

Cons: A withdrawal before retirement age can trigger a penalty on top of the taxes that you’ll owe on the distribution anyway, though you may be able to take an emergency withdrawal. Otherwise, you may be able to take out a loan against your account, though only if your plan offers it. Your investment options are limited to what’s available in your plan, and you may end up paying more for those investments than you would otherwise.

What it means for you: A 403(b) is like a traditional 401(k) but only for employees of certain organizations, and there are other differences, too. It’s an especially good option if you can receive a matching contribution since that offers an automatic and easy return on your money.

457(b)

A 457(b) plan is similar to a 401(k) in some ways, but it’s available only to employees of state and local governments and some tax-exempt organizations. It comes in two versions – one that offers pre-tax contributions and is not taxable until withdrawn and another that allows after-tax contributions in exchange for tax-free withdrawals in retirement. Contributions are limited to $19,500 in 2020, while those 50 and over can make a catch-up contribution of $6,500.

Pros: A 457(b) features both a pre-tax and after-tax version, giving employees a lot of flexibility in how they can save. The program may also offer a special benefit, increasing the maximum contribution to as much as twice the normal level in the three years leading up to an employee’s retirement age. Distributions before age 59 ½ are not subject to a 10 percent penalty tax either.

Cons: The typical 457(b) plan does not offer an employer match because it’s considered a supplementary retirement plan. It can be even tougher to take emergency withdrawals from a 457(b) than a 401(k), however. The costs for a 457(b) program may be higher as well.

What it means for you: The 457(b) is often used in addition to a government employee’s pension plan and accelerated contributions can be a welcome bonus for those who are able to take advantage of it. A 457(b) may offer a necessary benefit – penalty-free withdrawals – for those who have served their community and become injured early in life.

Plans for individuals

Retirement plans for individuals consist of two major options – the traditional IRA and the Roth IRA. The only qualification on contributing to an IRA is having earned income, though a spousal IRA gives non-wage earners the ability to save in the plan as well.

Traditional IRA

With a traditional IRA you can contribute money to the account and invest on a tax-deferred basis, letting your gains compound without immediately paying taxes. Your contributions are made with pre-tax income, meaning you’re not taxed on that income. Then when you hit retirement age (59 ½ or older), any withdrawals are taxed as ordinary income. The maximum annual contribution to a traditional IRA is $6,000 in 2020, and those 50 and older can add an additional $1,000 as a catch-up contribution.

Pros: The traditional IRA lets you take a break on today’s taxes, so you can save for retirement and have more money in your pocket, too. The tax-deferred growth allows your money to compound without taxes slowing its growth year to year. In a traditional IRA held at a brokerage, you can buy virtually anything trading on the exchange: stocks, bonds, funds, CDs and others.

Cons: The IRS will hit you with taxes and a 10 percent bonus penalty if you withdraw your money before retirement age. With an IRA, you’ll also have to know how to invest the money, or you can hire a financial adviser to help you do so. Another downside is that the tax-deductibility of your contribution can begin to decline if your modified adjusted gross income hits $65,000 (in 2020, for single filers who are covered by a plan at work.) Married filers and those without a workplace retirement plan may see higher thresholds or none at all. Required minimum distributions in retirement can force you to take out money even if you don’t otherwise need it.

What it means for you: The traditional IRA is a popular choice because of the deductibility of contributions, but be careful not to go over the income threshold. If you do, you can always convert the traditional IRA into a backdoor Roth IRA and enjoy other tax advantages. A traditional IRA is generally a better option than the Roth IRA if you’re in a relatively high tax bracket or expect to be in a lower bracket in the future.

Roth IRA

The Roth IRA might be the more popular option for individuals because it lets you avoid taxes entirely on distributions from the account at retirement. In exchange, you’ll pay taxes on the money going into the account, meaning you won’t enjoy a tax break today. The maximum annual contribution to a Roth IRA is $6,000 in 2020, and those 50 and older can add an additional $1,000 as a catch-up contribution.

Pros: The Roth IRA offers many benefits that go even beyond the appeal of tax-free withdrawals in retirement. With a Roth IRA held at a brokerage, you can invest in virtually anything trading on the exchange – offering you lots of flexibility. The plan also allows you to withdraw contributions (but not earnings) at any time penalty-free, giving you some control over your money. Once you hit 59 ½ years, you can withdraw any money in the account completely tax-free as long as you’ve had the account open at least five years. The Roth IRA even lets you withdraw money in a few other scenarios, such as paying for educational expenses. In addition, the account has no required minimum distributions, giving you flexibility to plan your income.

Cons: Having full control of your investments means that you’ll need to make all the decisions or hire someone to do that work for you. Technically, there are income limits on the Roth IRA, but you can otherwise (legally) create a backdoor Roth IRA to get money into the account.

What it means for you: It’s a long-running debate on which IRA – the traditional or the Roth – is a better option, but with so many advantages of the Roth it’s hard to go wrong there. Many financial advisers think the Roth IRA is the better of the two plans as well. In addition, the Roth offers various benefits when you’re planning your estate, letting you pass on tax-free income.

Spousal IRA

A spousal IRA allows a spouse who does not earn money to still contribute to an IRA as long as the other spouse earns income. The spousal IRA can be either a traditional IRA or Roth IRA, and has all the features of that IRA type.

Plans for small business

Retirement plans for small business and entrepreneurs consist of several plans, and the most popular options include the SEP IRA, the SIMPLE IRA and the solo 401(k). These plans are all about providing retirement options without getting into the headaches of legal paperwork.

SEP IRA

The SEP IRA works much like a traditional IRA but is available only for employees of a small business. Only the employer can contribute to the SEP IRA, and money goes into accounts for each individual employee. As a self-employed business person, you can set up a SEP IRA for just yourself. Contribution limits for 2020 are 25 percent of your income or $57,000, whichever is less.

Pros: The SEP IRA offers the same distribution and rollover rules as a traditional IRA, and allows an employee to grow their money tax-deferred until it’s taken out at retirement (age 59 ½), when it becomes ordinary taxable income. For workers who also run a side gig, the SEP IRA allows them to set aside more money than in a 401(k) plan. Because your SEP IRA is actually an employer plan, you can still contribute to a regular IRA as well. If your SEP IRA is set up at a brokerage, you’ll be able to invest in almost anything available at the brokerage.

Cons: Like many other retirement plans, an early withdrawal can lead to a 10 percent bonus penalty on top of regular tax rates. With a SEP IRA, you’ll also need to manage your investments or otherwise hire someone who knows how to do so. If you’re an employee, the amount that goes into the account entirely depends on the employer, and it can change from year to year, depending on the employer’s generosity and the profits of the business.

What it means for you: The SEP IRA can be a good way to really pile high the retirement savings, and you can amass your nest egg even while adding to other retirement plans. If you’re running a small business with employees, note that all employees must be treated equally in the plan (including yourself). So if you decide to make a contribution of 20 percent of salary, you must give everyone 20 percent of salary.

SIMPLE IRA

The SIMPLE IRA allows employees to deduct money from a paycheck and effectively contribute untaxed income. An employer must either: (1) match employees’ contributions dollar for dollar, up to 3 percent, or (2) contribute 2 percent of an employee’s wages up to $285,000 (in 2020). In terms of distributions and rollovers, the SIMPLE IRA works like a traditional IRA. Employees can defer up to $13,500 from their paycheck in 2020, while those over 50 can defer an extra $3,000.

Pros: The SIMPLE IRA allows employers to avoid complex federal reporting requirements that are required with 401(k) plans. For employees, the plan offers the tax-deferred growth and upfront tax benefits of a traditional IRA, in exchange for withdrawals being taxed in retirement. Any employer contribution is vested immediately and belongs to the employee. If the plan is managed by a brokerage, employees may have complete freedom of choice with investments.

Cons: Money withdrawn before retirement age (59 ½ or later) is subject to regular taxes and a bonus tax of 10 percent. Funds in a SIMPLE IRA are subject to required minimum distributions, so you’ll have to start taking distributions at age 72. Employee contributions are considered “elective deferrals” and count toward the annual limit on this and other retirement plans.

What it means for you: For an employer, the SIMPLE IRA offers an easy way to set up a retirement plan. For employees, it offers a convenient way to save in an employer-sponsored plan that offers a matching contribution. The SIMPLE IRA offers pros and cons relative to the SEP IRA, and these plans are two of the most popular options for small businesses.

Solo 401(k)

The solo 401(k) can be an attractive alternative to the SEP IRA and SIMPLE IRA, but it’s available only for one-person businesses or those employing just a spouse. The solo 401(k) gives a one-person business all the benefits of a big 401(k) plan without all the hassle. The plan comes in both traditional and Roth versions, so you can get a tax break on current contributions and tax-deferred growth or tax-free growth and withdrawals in retirement. An employee can contribute up to $19,500 in 2020, and the business can kick in as much as 25 percent of profits, as long as both contributions don’t exceed $57,000 combined in 2020.

Pros: A solo 401(k) is an attractive plan for one-person businesses because of the huge contribution limits, and since the employer is also the employee, he or she can decide exactly how much goes into the plan. Plus, the plan can be set up as either a Roth or traditional plan, allowing you great flexibility. And if you set up your plan with a brokerage, you can buy any security offered at the broker and are not limited to funds offered in a regular 401(k) plan. If your business is a side gig and you’ve already maxed your $19,500 contribution at your main job, you can still contribute up to 25 percent of your side gig’s profit to your own solo 401(k).

Cons: Managing your own investments can be more difficult than simply picking funds selected by the plan, so you may need to hire someone to help you. When the solo 401(k) surpasses $250,000 in assets, you’ll have to file an annual report with the IRS on Form 5500-SE. The solo 401(k) is not a good option if you expect your business to grow.

What it means for you: A solo 401(k) is a great selection if you’re a sole proprietor: You get to call all the shots and you can use the plan to maximize your savings, especially if you have another job. You may even be able to take a loan against your account, as you would in a typical employer-sponsored 401(k). The solo 401(k) often allows you to save more than in other plans, and this Bankrate calculator helps you figure out which small business plan is best.

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