If you are convinced that you should save (more) for retirement starting today, you may be wondering which retirement plans you should choose. It makes financial sense to first contribute the minimum amount towards your retirement plan at work (e.g., 401k) to get the maximum employer match. Only then you should think about contributing towards individual retirement plans (e.g., Traditional IRA and Roth IRA). The most popular retirement plans to which you can contribute as an individual or an employee are listed below.
Individual Retirement Arrangements (IRAs) – IRA is a way to save for retirement that gives you tax advantages.
- Traditional IRA – A traditional IRA is an individual retirement account that is used to save pre-tax dollars, subject to IRS limits, for use during retirement. Depending on where you open the account (local bank, brokerage or mutual fund company), you can invest that money in various available products such as CDs, stocks, bonds, mutual funds or a combination of these. The original contribution and the earnings from investment grow tax-deferred and will be taxed only once during retirement. With this plan, you make Uncle Sam a long-term partner in your investments.
- Roth IRA – A Roth IRA is similar to Traditional IRA except that the contributions are post-tax dollars, subject to IRS limits. Your investment returns and withdrawals in retirement are not taxed. Your income determines your eligibility to contribute to Roth IRA.
Employer-sponsored ‘Defined Contribution’ Plans
- IRA based plans
- Payroll Deduction IRA – Employees establish an IRA (either a Traditional or Roth IRA) with a financial institution and authorize a payroll deduction amount for it.
- Simplified Employee Pension (SEP) – Employers contribute to traditional IRAs (SEP-IRAs) set up for employees. If you are self-employed, you can setup a SEP for yourself (even if you have no employees) and contribute much higher amount compared to regular IRA.
- SIMPLE IRA – A SIMPLE IRA plan (Savings Incentive Match PLan for Employees) allows both employees and employers to contribute to traditional IRAs set up for employees. Employer contribution is mandatory whereas employee contribution is optional.
- 401(k) Plans – Retirement plan for employees of Corporations. A 401(k) plan allows eligible employees to make pre-tax contributions through payroll deductions. In addition, most employers make matching contributions based on employee’s contributions. However, the plan may require completion of a specific number of years of service for vesting in employer contributions. There are upper limits to the amount that you can defer on a pre-tax basis each year. The contributions and investment gains grow tax deferred and are taxed only once at the time of withdrawal. If you make withdrawals before age 59 ½, you may have to pay an additional 10% early withdrawal penalty.
- Roth 401(k) Plans – Roth 401(k) is similar to traditional 401(k) plan except that you pay tax on your contributions and your earnings and withdrawals in retirement aren’t taxed. So once you pay taxes on the contributions, the entire money in your account is never ever taxed.
- 403(b) Plans – 403(b) plan is similar to 401(k) plan, but available only for specific tax-exempt institutions, such as schools, colleges, universities, museums, hospitals, churches and other non-profit organizations. Employer contributions are rare in this plan and the investment options are limited to either annuities or mutual funds. This plan could include designated Roth contributions, which are after-tax contributions, which will then allow for tax-free earnings and withdrawals in retirement.
- Plans for Self-Employed People (Keoghs) – A qualified profit-sharing plan intended for self-employed individuals who own their own business. It can be setup as either a defined contribution or defined benefit plan. Although Keoghs require more administrative paperwork and have higher upkeep costs than SEP plans, they are more popular because the contribution limits are higher compared to SEP plans.
- Thrift Savings Plans (TSP) – TSP is similar to 401(k), but only for federal employees including the armed forces.
- 457 Plans – A non-qualified, deferred compensation plan like 401(k), but available only for state and municipal employees, as well as employees of qualified non-profit organizations. Unlike 401(k), independent contractors can also participate and there are no penalties for early withdrawals (although its not a good idea to make early withdrawals). Participants may be given the opportunity to treat elective deferrals as Roth contributions.