Gone are the days when workers could count on an employee pension plan and Social Security to cover their costs during those golden years. Today, pensions are a rarity and Social Security isn’t a slam-dunk for future generations since we have an aging population and fewer workers paying into the system.
Because of this, Uncle Sam
wants needs YOU to save for retirement. Offering tax breaks on retirement plans is the government’s way of enticing us to set aside money and employers to help out.
Here are some of the options you might have when it comes to tax-advantaged retirement savings.
Types of retirement plans
There is no shortage of tax-advantaged retirement plans designed to help people save. The most common are:
- Individual retirement plans: Traditional IRAs, Roth IRAs, Spousal IRAs, myRAs, rollover IRAs.
- Employer-sponsored retirement plans (or defined contribution plans): 401(k)s, Roth 401(k)s, 403(b)s (or TSAs), 457(b)s, Thrift Savings Plans.
- Retirement plans for the self-employed and small-business owners: SEP IRAs, Solo 401(k)s/Solo Roth 401(k)s, SIMPLE IRAs, payroll deduction IRAs, profit sharing.
» Save on taxes today: Use NerdWallet’s free retirement planning tool to see which investing accounts give you the most tax benefits.
The IRA is the big kahuna of retirement savings plans. An individual can set up an IRA at a financial institution, such as a bank or brokerage firm, to hold investments — stocks, mutual funds, bonds and cash — earmarked for retirement.
The IRS limits how much an individual can contribute to an IRA each year, and depending on the type of IRA, decides how the funds are taxed — or protected from taxation — when a participant makes deposits and withdrawals.
Main advantages of IRAs
- They put you in the driver’s seat. You choose the bank or brokerage and make all the investment decisions, or hire someone to make them for you.
- Depending on the type of IRA you choose — Roth or traditional — and based on your eligibility, you decide how and when you get a tax break.
- IRAs provide a much wider range of investment choices than workplace retirement plans do.
- If you qualify for both a Roth and a traditional IRA in the same year, you can contribute to both! Your total contributions must remain below the combined IRA contribution limit. But the “two-fer” does get you some tax diversification in your retirement portfolio.
Main disadvantages of IRAs
- IRAs have lower annual contribution limits than most workplace retirement accounts: $5,500 per year versus $18,000 for 401(k)s, or for those over age 50, $6,500 versus $24,000 — in 2017.
- Roth IRA contribution limits are based on your modified adjusted gross income, and the amount you’re allowed to contribute begins to decrease for single taxpayers who make more than $118,000 and married, joint filers who make more than $186,000.
- Income, tax filing status and access to a workplace retirement plan affect how much of a traditional IRA contribution you can deduct. To qualify for a full deduction, single filers must have a modified adjusted gross income of $62,000 or less and joint filers must make $99,000 or less.
- Choosing between a Roth and a traditional IRA requires you to guess what your tax situation will be when you start drawing from the account.
5 types of IRAs
Traditional IRA Roth IRA Spousal IRA (traditional or Roth) MyRA Rollover IRA (aka conduit IRA)
Funding You fund at a financial institution You fund at a financial institution Set up under nonworking spouse’s name; funded by either spouse Set up and funded by you through myra.gov You fund with money from a qualified plan (e.g., a 401(k) from a past employer)
2017 contribution limits $5,500; $6,500 for those age 50 and older
(More on traditional IRA contribution limits.)
$5,500; $6,500 for those age 50 and older
(More on Roth IRA contribution limits.)
$5,500; $6,500 for those age 50 and older
(See IRS.gov rules on Spousal IRA contribution limits.)
$5,500; $6,500 for those age 50 and older No limits on rollover contributions; IRA limits apply to additional contributions
Taxes and contributions Contributions might be deductible; earnings grow tax-deferred and investment income is deferred Contributions aren't deductible; earnings grow tax-free Follows same rules as traditional or Roth IRAs, depending on type Contributions aren't deductible; earnings grow tax-free No deductions for rollover amount; earnings grow tax-free
Taxes on withdrawals after age 59½ Taxed at ordinary rates; tax-free withdrawals of nondeductible contributions Distributions aren't taxed Follows same rules as traditional or Roth IRAs, depending on type Distributions aren't taxed Follows same rules as traditional or Roth IRAs, depending on type
Pros Deductible contributions lower your tax burden for the year you make them Distributions in retirement aren't taxed
More lenient rules for early withdrawals
Allows nonworking spouse to accrue tax-advantaged retirement savings No minimum investment requirement to open an account; no fees;
If rolling over money from a past employer’s 401(k), you get to take more control
Cons Deductibility is based on income, filing status and whether you (and/or your spouse) have a workplace retirement plan; requires minimum yearly withdrawals starting age 70 ½ Eligibility to contribute phases out based on income; only offers tax savings if your tax rate is higher in retirement Nonworking spouse subject to the same contribution and deductibility limits as working spouse
(See the IRS rules about deductions for Spousal IRAs)
Investment choice limited to bonds backed by U.S. government; when balance hits $15,000, it rolls over into a private Roth IRA Rollover into an account with a different tax treatment (e.g. from a 401(k) into a Roth IRA) counts as a conversion and triggers income taxes on original contributions
Good to know Must have earned income in order to contribute Must have earned income in order to contribute Must file a joint tax return in order to be eligible Contribution limits are based on the Roth rules Abide by the 60-day rule when completing a 401(k) rollover to avoid penalties and taxes
Sources: IRS.gov, Fidelity.com, Schwab.com, Vanguard.com
401(k)s and other employer-sponsored retirement plans
Human resource departments cover a lot during new employee orientation. Pay close attention, because there may be a pot of gold — information about a workplace retirement plan — buried in the pile of paperwork you’ve been asked to initial and sign.
There are two main types of employer-sponsored retirement plans:
Defined benefit plans: Perhaps you’ve heard references to pension plans in black-and-white movies or when elderly relatives reminisce about the “good old days.” In olden times, some companies guaranteed workers a set benefit in retirement based on their years of service and average salary. The company kicked money into a single retirement pool and the pension plan invested it, hopefully earning enough to make good on its promise of retirement support. In these modern times, you might happen upon an employer that makes annual contributions to a retirement plan based on a similar formula, but without any promise or guarantee of the benefit provided in retirement.
Defined contribution plans: This type of plan is now the more common type of workplace retirement plan. Employers set up these plans, usually 401(k)s, to enable employees to contribute to an individual account within the company plan — typically via payroll deduction. If you come across the words “company match” in your benefits paperwork, that means you’ve hit the jackpot: an employer-sponsored retirement plan in which the company contributes to your account based on your personal contribution level (e.g., a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6%).
» MORE: 401(k) calculator
Main advantages of defined contribution plans:
- They’re easy to set up and maintain. Most employers offer an automatic payroll deduction option for deposits into the plan, and the retirement plan administrator (a separate financial institution) handles statements, disclosures and updates.
- Your employer might match a portion of your contribution. (This is free money!)
- 401(k) contribution limits are higher than those for IRAs.
- Employee contributions (to non-Roth plans) reduce your taxable income for the year. Because of that upfront tax break you’ll owe taxes on the withdrawals you make in retirement. Roth 401(k) contributions don’t offer any immediate tax break; contributions are made with after-tax money. However, withdrawals from the account are tax-free in retirement.
- The Roth 401(k) has no income restrictions, unlike the Roth IRA.
- Participant-directed plans give employees control of investments. You decide how much of your contribution to direct into each investment among the options within the plan.
Main disadvantages of defined contribution plans:
- Investment choices within employer-sponsored retirement plans are limited to certain funds, leaving you with fewer options than in a self-directed IRA. If you have limited retirement dollars, here’s how to decide if it’s better to invest in an IRA or a 401(k).
- Management and administrative fees can be high and dramatically erode investment returns over time. Use our FeeX 401(k) fee finder tool to find out how much you’re paying in fees in your retirement plan.
- New employees might have a waiting period before they can contribute to a plan (e.g., 30 to 90 days of employment).
- Employer contributions might be subject to a vesting schedule, in which money becomes the property of employees only after they have worked for the company for a certain amount of time.
5 types of employer-sponsored retirement plans
401(k)/Roth 401(k) 403(b) (aka TSA or Tax-Sheltered Annuity) 457(b) Defined Benefit Plan TSP (Thrift Savings Plan)
Offered by Public or private for-profit companies
Tax-exempt organizations or churches (e.g. public schools, hospitals, religious groups) State and local governments; some tax-exempt entities; contractors Public or private companies; self-employed, high-income individuals Federal Employees Retirement System, for U.S. civil service employees and members of the military
2017 contribution limits $18,000; $24,000 for those age 50 and older $18,000; $24,000 for those age 50 and older; lesser of $54,000 or 100% of compensation if employer matches $18,000; might allow catchup contributions (up to $36,000) for those age 50 and older and/or employees three years from retirement age Determined by employer annually; self-employed individuals can make contributions based on age, expected return and desired benefit $18,000; $24,000 for those age 50 and older
Funded by Employee deferral; optional employer contributions Employee deferral; optional employer contributions Employee deferral; optional employer contributions Employer Employee deferral; employer contributions based on participant contribution
(See details at TSP.gov.)
Taxes on contributions and earnings Deferred taxes on traditional 401(k) contributions; taxes paid up front for Roth 401(k) contributions; earnings grow tax-deferred Contributions are pretax; taxes are deferred; earnings grow tax-free Contributions are pretax; taxes are deferred; earnings grow tax-free Contributions are tax-deductible (for the employer); earnings grow tax-free Contributions to a traditional plan are tax-deferred, contributions are paid up front for Roth plans; earnings grow tax-free
Taxes on withdrawals after age 59 1/2 Traditional plan withdrawals taxed at ordinary rates; Roth 401(k) distributions aren't taxed Taxed at ordinary rates at time of withdrawal Taxed at ordinary rates at time of withdrawal Taxed at ordinary rates at time of withdrawal Traditional plan withdrawals taxed at ordinary rates; Roth 410(k) distributions aren't taxed
Pros Employer might match contributions; if employer offers traditional and Roth 401(k)s, participants can fund both up to annual limit of $18,000 (or $24,000 for those age 50 and older) Has higher limits for matches than 401(k); optional 15-year rule allows catchup contributions up to a $15,000 lifetime max If employer offers a 403(b)or 401(k) in addition to the 457, workers might be eligible to contribute to both; no early withdrawal penalty if you leave job; contractors are eligible Predictable retirement benefit; employers get higher deduction for offering this plan Employees receive matching funds even if they don't contribute; offers low-cost investment options
Cons Investment choices might be limited; plan fees can be high
(Use the FeeX 401(k) fee finder tool to see.)
Investments sometimes limited to high-fee mutual funds and/or variable annuity multiyear contracts Doesn't offer a Roth feature; no qualified early withdrawals allowed Complex and costly to establish Three-year vesting schedule for all agency contributions and earnings; limited investment options
Good to know Roth 401(k) requires you start taking minimum distributions at age 70½, unlike a Roth IRA Employees with 15 years of service might qualify for $3,000 in catchup contributions each year for 5 years Participants might qualify for the Retirement Saver’s Credit Less control over contribution amounts and investments Federal employees also have a defined benefit plan
Retirement plans for small-business owners and self-employed individuals
According a 2015 U.S. Department of Labor report, 34% of workers don’t have access to a workplace retirement plan. At companies with fewer than 100 workers, roughly half of employees are offered a retirement savings plan.
If you work at or run a small company or are self-employed, you might have a different set of retirement plans at your disposal. Some are IRA-based, while others are essentially single-serving-sized 401(k) plans. And then there are profit-sharing plans, which are a type of defined contribution plan.
Main advantages of plans for the self-employed:
- Plans for contractors, the self-employed and small-business owners have higher contribution limits than most employer plans and IRAs.
- These plans often offer more investment choices than employer-sponsored plans, such as 401(k)s.
- Many of these plans are easy to set up and therefore not much of a burden on the employer — that’s you, if you’re a small-business owner.
- You might be able to set up your account at a financial institution you already use.
- If you’re self-employed, you can give yourself a generous profit-sharing contribution, plus make your elective deferral — with catchup — as the employee.
Main disadvantages of plans for the self-employed:
- Employer contributions might be completely discretionary, putting more of the savings burden on employees/plan participants.
- Setup and administrative duties for more complicated plans fall to the employer — which might be you.
- Some plans have narrower parameters for allowable early withdrawals than traditional IRAs and employer-sponsored retirement plans.
- Loans from some plans must meet certain requirements and require the participant to apply.
- For the self-employed, the profit-sharing cap boils down to about 20% of net profits because of Federal Insurance Contribution Act taxes due on net profits.
5 retirement plans for the self-employed and small-business owners
SEP IRA Solo 401(k)/Solo Roth 401(k) SIMPLE IRA Payroll deduction IRA Profit Sharing
Best for Self-employed people; employers with one or more employees Self-employed people with no employees other than a spouse Self-employed people; businesses with up to 100 employees Self-employed people; employers with one or more employees Self-employed people; employers with one or more employees
Funded by Employer; individual, if self-employed Self or qualified spouse Employee deferrals; employer contributions Employee, via payroll deduction Employers, at their discretion; might be linked with employer’s workplace retirement plan
2017 employee contribution limits Contributions for employees made solely by employer (or sole proprietor); limit of 20% of net self-employment income, to a maximum of $54,000 Lesser of $18,000 or $24,000 for those age 50 and older and 100% of earned income $12,500; $15,500 for those age 50 or older Based on employee’s IRA eligibility; maximum of $5,500; $6,500 for those age 50 and older Based on employee’s IRA eligibility; maximum of $5,500, or $6,500 for those age 50 or older
20167employer contribution limits The lesser of up to 25% of employee compensation or $54,000 As both an employee (of yourself) and employer, up to $54,000, or $60,000 with catchup contribution Mandatory 3% matching contribution or fixed contribution of 2%, up to $5,000 per employee N/A The lesser of up to 25% of employee compensation or $54,000
Taxes on contributions and earnings Contributions and investment income are tax-deferred; earnings grow tax-deferred Contributions and investment income in a traditional Solo 401(k) are tax-deferred; contributions to a Solo Roth 401(k) are taxable; earnings grow tax-free Contributions and investment income are tax-deferred; earnings grow tax-deferred Contributions to a traditional IRA might be deductible; contributions to a Roth are taxable;
earnings grow tax-deferred
No taxes on contributions;
earnings grow tax-deferred
Taxes on withdrawals after age 59 1/2 Taxed at ordinary rates Traditional Solo 401(k) withdrawals are taxed at ordinary rates; Solo Roth(401)k withdrawals aren't taxed Taxed at ordinary rates Traditional withdrawals are taxed at ordinary rates; Roth withdrawals aren't taxed Taxed at ordinary rates
Pros Simpler for employers to set up than Solo 401(k)s; employers get tax deductions on contributions Allows small-business owners to make both employee and employer contributions for themselves; has higher contribution limits than some other plans Employees can contribute up to 100% of compensation, up to limit Easy to set up and maintain; no minimum employee coverage requirements Employee might be able to borrow penalty-free from vested balance before retirement age (although borrowed amounts are subject to income tax)
Cons Lower contribution limits for sole proprietor than a Solo 401(k); doesn't allow catchup contributions; employer contributions are discretionary More complicated to set up than a SEP IRA; only allows withdrawals before age 59 ½ for disability or plan termination 25% penalty on distributions made before age 59 ½ and within the first two years of the plan; no loans allowed Employees subject to Roth and traditional IRA eligibility requirements Vesting period is generally required; no diversification, tied to employer earnings
Good to know There is a different calculation to determine allowable SEP contributions if you're both the employer and employee
(See the IRS SEP IRA worksheet.)
Employer contributions might be subject to vesting terms Distribution rules penalize rollovers to another account within the first two years of plan ownership; a SEP IRA or Solo 401(k) might be better for the self-employed The employer chooses the provider Contributions are at employer’s discretion and can vary by year; employee share based on salary and job level