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 plans. Here’s how to make sense of the acronym-rich list of options — IRAs, SEPs, 401(k)s, 403(b)s and more — to find the right retirement accounts to save for your future.
Which retirement accounts are best for you?
- If you have a 401(k) or other workplace retirement plan … then first contribute enough to get any free money offered by your employer via the company match. Employer-sponsored retirement plans include 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. Which type of IRA is best for you? We’ve outlined the pros and cons of four types of IRAs: Traditional IRA, Roth IRA, Spousal IRA, Rollover IRA.
- If you are self-employed or the owner of a small business … there are retirement accounts designed specifically for you. They include the SEP IRA, Solo 401(k) (Roth and traditional), SIMPLE IRA and profit sharing.
We’ll walk you through the various plans below. (Or, check out our post on how to choose a financial advisor if you feel like you want outside help to manage it all for you.)
» Get your retirement on track: NerdWallet’s guide to retirement planning
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.
» Get the right individual retirement account. Click to see our analysis of the best IRA providers.
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: In 2019 the maximum is $6,000 per year in an IRA versus $19,000 in a 401(k). For those over age 50 the limits are higher: $7,000 versus $25,000. This is one consideration in the IRA vs. 401(k) debate.
- 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 in 2019 make more than $122,000 and married, joint filers who make more than $193,000.
- Income, tax filing status and access to a workplace retirement plan affect how much of a traditional IRA contribution you can deduct. For example, to qualify for a full deduction if you have a retirement plan at work, single filers must have a modified adjusted gross income of $64,000 or less and joint filers must make $103,000 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. Although 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||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||Must have earned income in order to contribute|
|Roth IRA||Distributions in retirement aren't taxed |
More lenient rules for early withdrawals
|Eligibility to contribute phases out based on income; only offers tax savings if your tax rate is higher in retirement||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|
(See the IRS rules about deductions for 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||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 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 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%).
» 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.
- 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
|Pros||Cons||Good to know|
|401(k)/Roth 401(k)||Employer might match contributions; if employer offers traditional and Roth 401(k)s, participants can fund both up to annual limit of $19,000 (or $25,000 for those age 50 and older)||Investment choices might be limited; plan fees can be high |
(Use the FeeX 401(k) fee finder tool to see.)
|Roth 401(k) requires you start taking minimum distributions at age 70½, unlike a Roth IRA|
|403(b) (aka TSA or Tax-Sheltered Annuity)||Has higher limits for matches than 401(k); optional 15-year rule allows catchup contributions up to a $15,000 lifetime max||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)||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||Doesn't offer a Roth feature; no qualified early withdrawals allowed||Participants might qualify for the Retirement Saver’s Credit|
|Defined Benefit Plan||Predictable retirement benefit; employers get higher deduction for offering this plan||Complex and costly to establish||Less control over contribution amounts and investments|
|TSP (Thrift Savings Plan)||Employees receive matching funds even if they don't contribute; offers low-cost investment options||Three-year vesting schedule for some agency contributions and earnings; limited investment options||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|
|2018/2019 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 $56,000 (up from $55,000 in 2018)||Lesser of $19,000 or $25,000 for those age 50 and older and 100% of earned income||$13,000; $16,000 for those age 50 or older (up from $12,500 and $15,500 in 2018)||Based on employee’s IRA eligibility; maximum of $6,000; $7,000 for those age 50 and older (up from $5,500 and $6,500 in 2018)||Based on employee’s IRA eligibility; maximum of $6,000, or $7,000 for those age 50 or older (up from $5,500 and $6,500 in 2018)|
|2018/2019 employer contribution limits||The lesser of up to 25% of compensation or $56,000 (up from $55,000 in 2018)||As both an employee (of yourself) and employer, up to $56,000, or $62,000 with catchup contribution (up from $55,000 and $61,000 in 2018)||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 $56,000 (up from $55,000 in 2018)|
|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|
Take the next step with your retirement investments
- Decide between a Roth IRA vs. traditional IRA
- Review the directions on how and where to open a Roth IRA or a traditional IRA.
- Have money in an old 401(k)? See our complete guide to 401(k) rollovers
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.