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.
That’s why Uncle Sam
wants needs YOU to save for retirement and is offering tax breaks on retirement accounts. Here’s how to to find the best retirement plans to save for your future.
Which retirement accounts are best for you?
- If you have a 401(k) or other workplace retirement plan: First contribute enough to get any free money offered by your employer via the company match. For more on the pros and cons of these plans, jump to our section on employer-sponsored retirement plans, including 401(k)s, 403(b)s, 457(b)s, defined benefit plans and TSPs.
- If you’ve maxed out your 401(k) or you don’t have a retirement plan at work: Consider an IRA. Jump to our section on the pros and cons of four types of IRAs, including traditional and Roth IRAs. If you already know you want an IRA, check out our round-up of the best IRA providers.
- If you’re self-employed or the owner of a small business: Jump to our section about retirement accounts designed specifically for you, including the SEP IRA, Solo 401(k), SIMPLE IRA and profit sharing.
We’ll walk you through the various plans below. (Or, if you want someone to help you, check out our post on how to choose a financial advisor.)
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 (here’s a rundown of 7 types of IRAs), 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.
If you like the idea of opening an IRA, be sure to look for a provider with low fees. Here are some of our favorites from our analysis of the best IRA account providers:
Main disadvantages of IRAs
- IRAs have lower annual contribution limits than most workplace retirement accounts: In 2020, the maximum amount you can put in an IRA is $6,000 ($7,000 if you’re 50 or older), compared with the $19,500 annual maximum for a 401(k) (which jumps to $26,000 for people age 50 or over). This is one consideration in the IRA vs. 401(k) debate.
- Roth IRA contribution limits are based on your modified adjusted gross income. The amount you’re allowed to contribute begins to decrease once you hit $124,000 (single taxpayers) or $196,000 (married filing jointly taxpayers) in 2020. The 2019 limits started at $122,000 (single taxpayers) and $193,000 (married filing jointly).
- With a traditional IRA, anyone can contribute, no matter what their income. But your ability to deduct your contributions may be limited if you (or your spouse) has a retirement plan at work. If you do, check out the IRA contribution limits.
- 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. For some, the immediate tax break of the traditional IRA might make that account more appealing; for others, the prospect of tax-free income in retirement makes the Roth the clear winner. We argue in our Roth vs. traditional IRA comparison that the Roth is a better choice for most eligible retirement savers.
4 types of IRAs
|Pros||Cons||Good to know|
|Traditional IRA||Deductible contributions lower your tax burden for the year you make them||Must have earned income in order to contribute|
|Roth IRA||Must have earned income in order to contribute|
|Spousal IRA (traditional or Roth)||Allows nonworking spouse to accrue tax-advantaged retirement savings||Nonworking spouse subject to the same contribution and deductibility limits as working spouse (read more about spousal IRAs)||Must file a joint tax return in order to be eligible|
|Rollover IRA (aka conduit IRA)||If rolling over money from a past employer’s 401(k), you get to take more control||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|
Sources: IRS.gov, Fidelity.com, Schwab.com, Vanguard.com
401(k)s and other employer-sponsored retirement accounts
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. The company kicked money into a single retirement pool and the pension plan invested it. These plans are rare now. Still, you might happen upon an employer that makes annual contributions to a retirement plan based on a similar formula, but without any guarantee of the benefit provided in retirement.
Defined contribution plans: These are now the most common type of workplace retirement plan. Employers set up these plans, such as 401(k)s and 403(b)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 got access to some free money: 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%).
» How much should you save? Check out our 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.
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 an 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 erode your investment returns over time.
- 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
|Pros||Cons||Good to know|
|401(k)/Roth 401(k)||Roth 401(k) requires you start taking minimum distributions at age 72, unlike a Roth IRA (Roth IRAs have no required distributions)|
|403(b) (aka TSA or Tax-Sheltered Annuity)||Investments sometimes limited to high-fee mutual funds and/or variable annuity multiyear contracts||Employees with 15 years of service might qualify for $3,000 in catchup contributions each year for 5 years|
|457(b)||Participants might qualify for the Retirement Saver’s Credit|
|Defined Benefit Plan||Complex and costly to establish||Participants have less control over contribution amounts and investments|
|TSP (Thrift Savings Plan)||Federal employees also have a defined benefit plan|
Retirement accounts 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|
|2020 employee contribution limits||Contributions for employees made solely by employer (or sole proprietor); limit of 25% of net self-employment income, to a maximum of $57,000||Lesser of $19,500 ($26,000 for those age 50 and older) and 100% of earned income||$13,500; $16,500 for those age 50 or older||Based on employee’s IRA eligibility; maximum of $6,000; $7,000 for those age 50 and older||N/A|
|2020 employer contribution limits||The lesser of up to 25% of compensation or $57,000||As both an employee (of yourself) and employer, up to $57,000, or $63,500 with catchup contribution||Mandatory matching contribution of up to 3% of an employee's compensation or fixed contribution of 2%||N/A||The lesser of up to 25% of employee compensation or $57,000 ($63,500 including catch-up contributions)|
|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|
A previous version of this article misstated one of the downsides of the Thrift Savings Plan. Only some contributions and earnings are on a three-year vesting schedule. This article has been corrected.