Choosing the right home for your retirement savings is just as important as saving for retirement in the first place. Your retirement plan dictates how much you can contribute annually, how it's taxed, how withdrawals work, and even what you can invest in and how much you pay in fees.
To help you decide which retirement plans work best for your savings needs, consider the following options. We’ll cover employer-sponsored plans, individual retirement accounts, and plans for self-employed individuals and small business owners.
A 401(k) is the most common type of employer-sponsored retirement plan. Your employer preselects a few investment options for you to choose from, and then you defer a portion of each paycheck to the account. If you leave your job, you may take your 401(k) funds with you or leave them where they are to continue growing.
In 2020, you can contribute up to $19,500 to a 401(k), plus an additional $6,500 if you're 50 or older. Some employers also match a portion of employee contributions. With few exceptions, you cannot withdraw funds from your 401(k) before 59 1/2 without penalty.
|401(k) pros||401(k) cons|
|High contribution limits||Limited investment options|
|Tax savings||Fees can be high|
|Employer matching||Early withdrawal penalties before 59 1/2|
|Loans available with some plans|
If you hope to get the most out of your 401(k), you should contribute as much as you are able to, and choose your investments carefully to minimize your fees. You should also claim any employer match that's available and watch out for your company's vesting schedule, which determines when you get to keep employer-matched funds, so you don't accidentally lose this money if you quit your job.
- Tax benefits: Most 401(k)s are tax-deferred, which means your contributions reduce your taxable income this year, but then you pay taxes on your distributions in retirement. This is usually the better option if you believe you're in a higher tax bracket today than you'll be in once you retire. By delaying taxes until later when your income is lower, you'll owe a smaller percentage to the government.
But Roth 401(k)s are also growing in popularity. Contributions to these accounts don't reduce your taxable income for the year, but the money grows tax-free afterward. You'll save more in taxes with a Roth 401(k) if you believe you're in the same or a lower tax bracket today than you'll be in once you retire. Employer-matched funds are still tax-deferred with these plans.
- 401(k) loans: Some 401(k)s allow loans. This enables you to borrow against your retirement savings and pay back that money with interest over time. But if you fail to pay back everything you borrow by the end of the loan term, the government taxes the outstanding balance as a distribution.
- Required minimum distributions (RMDs): Beginning when you turn 72 (or 70 1/2 if you reached this age before 2020), you must begin taking required minimum distributions (RMDs) from your 401(k)s. You can determine the amount you must withdraw by dividing the value of your 401(k) by the distribution period next to your age in this IRS worksheet. Failure to withdraw at least your RMD each year results in a 50% penalty on the amount you should have withdrawn.
Roth 401(k)s also require RMDs, though you will only owe taxes on your withdrawn earnings, not your contributions. You can get around Roth 401(k) RMDs altogether by rolling the money into a Roth IRA, discussed below, which does not have an RMD requirement.
Other employer-sponsored retirement plans
403(b) and 457 plans are other types of employer-sponsored retirement plans you may come across.
An individual retirement account (IRA) is a retirement account anyone may open and contribute to, as long as they are earning income during the year or are married to someone who is.
IRAs offer a much greater variety of investment options than most employer-sponsored retirement plans.
That, coupled with the fact that you can open an IRA with any broker you want, means you may be able to keep your fees much lower with an IRA than you could with one of the plans listed above.
|IRA pros||IRA cons|
|Wide variety of investment options||Low contribution limits|
|Almost anyone can contribute||High-income earners cannot contribute to Roth IRAs|
|Tax savings||Early withdrawal penalties before 59 1/2|
|Fees can be lower than with employer-sponsored plans||No employer matching|
Getting the most out of your IRA involves choosing your broker and your investments carefully to minimize fees, while keeping your investments diverse and well-matched to your risk tolerance. You should also choose the right type of IRA -- traditional or Roth -- based on which you think will give you the greatest tax advantages, and contribute as much as you can each year.
- Tax savings: Traditional IRAs are tax-deferred -- that is, your contributions are made with pre-tax dollars, so they lower your taxable income for the year and you pay taxes on distributions in retirement. Roth IRAs are funded with after-tax dollars, so your contributions have no effect on your taxes this year, but you can then withdraw your savings tax-free in retirement.
- Contribution limits: In 2020, you can only contribute up to $6,000 to an IRA, plus an additional $1,000 if you're 50 or older. You may contribute to an employer-sponsored retirement plan and an IRA in the same year, and you may contribute to tax-deferred and Roth accounts at the same time, but you may not make more than $6,000 (or $7,000 if 50+) in combined traditional and Roth IRA contributions in 2020.
- Required minimum distributions (RMDs): Traditional IRAs have RMDs when you turn 72, or 70 1/2 if you reached this age before 2020. Roth IRAs do not have RMDs.
Types of IRAs
In addition to traditional IRAs, there are several types of IRAs to consider. Here are a few key alternatives.
Retirement plans for the self-employed and small business owners
Self-employed individuals and small business owners may contribute to an IRA, but there are also several special retirement plans available just for them that enable them to contribute more money per year, since they don't receive the benefit of an employer-sponsored retirement plan. Here's a look at some of the most common retirement plans for small business owners and the self-employed.