A retirement plan is a savings account you set up during your working years that helps you support yourself once you reach retirement. These savings plans come in many forms, including the 401(k), IRA and more. Usually, a retirement plan is set up to take advantage of an area of the tax code that grants special tax benefits for retirement savers. Using at least one retirement plan to build a nest egg is crucial element to saving for retirement.
The type of retirement plan you want depends on what you’re looking for. Do you want a plan that you can get through an employer, like a pension or 401(k)? If you are self-employed, you can look into the Solo 401(k), SEP IRA, or Simple IRA, each with its own pros and cons. Below, we discuss some of the more popular retirement plans and how they work.
Pension plans are defined benefit plans. They are funded by your employer, who invests money on your behalf. Your employer promises you a defined amount of money when you retire, no matter what happens with the investments. Generally, the amount of money you get depends on how many years you worked for the company, your salary, and your age. Payouts can be lump-sum or monthly.
During the early 1980s in the United States, 60% of workers in the private sector had a defined pension plan as their only retirement account. Today, about 90% of public sector employees and 10% of private sector employees are covered by a pension plan.
401(k), 403(b), and 457(b)
401(k)s are the employer-sponsored plan that has largely replaced the pension in the private sector. 401(k)s are defined-contribution plans, which means that you fund your plan instead of your employer. However, some employers do match 401(k) contributions, typically up to 6%. If your employer matches contributions, make sure you put in enough money to at least get the matching contribution.
If you are younger than age 50, you can contribute up to $19,000 a year to a 401(k). Starting at 50, you can contribute up to $25,000 a year. The money you contribute and the earnings you make are tax-deferred until you make withdrawals. That means you can deduct the amount you contribute to your 401(k) from your taxable income. You pay income taxes on contributions and earnings when you withdraw the money.
If you withdraw funds from your 401(k) before the age of 59.5, the withdrawal would be subject to federal and state income taxes, and you could even pay a 10% penalty. Some plans do offer 401(k) loans if you find yourself in an emergency.
If you are younger than age 50, you can contribute up to $6,000 a year to an IRA. Starting at 50, you can contribute up to $7,000 a year. Like a 401(k), the money you put into your IRA is tax-deferred until you make withdrawals. However, if you are covered by a retirement plan like a 401(k) at work, you might not be able to deduct your IRA contributions from your taxable income.
If you take money out of your IRA before you turn 59.5, you will probably have to pay a 10% penalty fee, as with a 401(k), although you may be eligible to to avoid a penalty in certain circumstances. You will also be subject to federal and state and income taxes on your withdrawal.
- Single Filers: If you are not covered by a retirement plan at work, you will get the full tax deduction no matter what your income.
- If you are covered by a retirement plan at work, and you are making $64,000 or more a year, you only get a partial deduction. If you are covered by a retirement plan at work and making more than $74,000 a year, you cannot deduct IRA contributions from your taxable income.
- Joint Filers: If you file jointly with your spouse and one or both of you have a retirement plan through work, the tax deduction depends upon your joint income.
- If your joint income is more than $103,000 a year, you only get a partial deduction. If your joint income is more than $123,000 a year, you cannot deduct IRA contributions from your taxable income.
When you have a Roth IRA, you contribute after-tax dollars, and get no tax deduction for your contribution. However, any earnings you make with the money in your Roth IRA are not taxed, and you pay no money on withdrawals you make after the age of 59.5. The contribution limits on a Roth IRA are the same as the contribution limits on a traditional IRA.
You can also have both a Roth IRA and an IRA. However, the combined contributions cannot exceed $6,000, or $7,000 if you are older than age 50.
You can also withdraw the amount you contributed to your Roth IRA at any time without a penalty, and with no taxes due. However, there will be taxes due on the earnings if you take that money out before the age of 59.5.
- Single Filers: If you make more than $122,000 a year, your allowed contribution is reduced. You must make less than $137,000 a year in order to contribute to a Roth IRA.
- Joint Filers: If you make more than $193,000 a year, your allowed contribution is reduced. You must make less than $203,000 a year in order to contribute to a Roth IRA.
If you have a traditional IRA or a 401(k) the tax benefit you get is a tax-deferral, meaning that you get a tax-deduction on the income you invest into your IRA or 401(k). Your income grows, untaxed, until you make withdrawals in retirement.
If you have a Roth IRA or Roth 401(k), the money you put into the account is after-tax dollars. The earnings you make with those after-tax dollars are untaxed as long as you don’t take the money out early.
The type of account you choose will depend on how you want to save money. Do you want to take a tax deduction now, and have your earnings grow untaxed until you withdraw money (with a traditional IRA), or do you not want to have to worry about your earnings being taxed later (as with a Roth IRA)?
Retirement Accounts for the Self-Employed
Self-employed persons also have some variety when it comes to choosing retirement plan options.
- You can make contributions to a Solo 401(k) as both the employee and employer. In 2019, you can contribute up to $56,000 a year if you are under the age of 50, or up to $62,000 a year if you are age 50 or older.
- If you have a Solo Roth 401(k), your contributions are taxable but your earnings grow tax-free and your withdrawals are not taxed.
- The Simplified Employee Pension IRA (SEP IRA) is used mainly by the self-employed or by small business owners. In 2019, as the employer, you can contribute up to 25% of your income or up to $56,000 – whichever is less.
- It is easier to set up an SEP IRA than a Solo 401(k).
- If the small business has employees, the employer must contribute for all employees who meet certain criteria.
- The SIMPLE IRA is the Savings Incentive Match Plan for Employees
- It allows small employers – defined as those with fewer than 100 employees – to set up IRAs with less paperwork.
- It is similar to a 401(k). Contributions and earnings on those contributions are tax-deferred until retirement.
- Employers can either match employee contributions or make unmatched contributions
- An employee can contribute up to $13,000 if they are under 50 years old, for up to $16,000 if they are over fifty
- If you take money out of your SIMPLE IRA within two years of opening the plan and before the age of 59.5, you can face a fine of 25%.
- You cannot borrow from a SIMPLE IRA, although you can borrow from a 401(k) in some circumstances
You can roll over 401(k) funds into a traditional IRA, where your money can continue to grow, tax-deferred. You can also roll over 401(k) funds into a Roth IRA, or roll over IRA funds into a Roth IRA.
If you convert some or all of a traditional IRA or 401(k) to a Roth IRA, you will pay taxes on the amount you convert that year. However, all future earnings and withdrawals from your Roth IRA will be tax-free.
Essentially, you can move funds from one retirement account to another without being penalized.
The Bottom Line
There are many different ways to save for retirement. While many companies have moved away from the pension plan system, you have many tax-advantaged retirement saving options at your fingertips, and you can open several different types of retirement accounts in order to maximize your retirement savings.
Tips to Help You Figure Out Your Retirement Strategy
- If you want help figuring out what retirement plan or plans are right for you, consider working with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Having an accurate sense of your cost of living can better help you prepare how much you’re going to need to save for retirement. You can save accordingly now in order to save yourself from trouble later. Use our retirement calculator to get a comprehensive breakdown.
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