Retirement Account Options

Types of Retirement Plans

There are several types of retirement plans available:

1. Defined Contribution Plans (AKA 401(k)/403(b)/457(b) plans)
2. IRA Plans
3. Solo 401(k) plan
4. Defined Benefit Plans (AKA Pensions)
5. Guaranteed Income Annuities (GIAs) 6. Profit-sharing plans
7. Cash-balance plans
8. Cash-value life insurance plans
9. Nonqualified deferred compensation plans

What we’ll be focusing on are the first three, which are the most common and where most questions typically revolve around.

1. Defined Contribution Plans

Defined Contribution Plans are an umbrella term used to refer to 401(k)’s, 403(b)’s, and 457(b)’s. The primary difference between these three plans is kind of employer providing it. 401(k)’s is the most commonly known one offered by employers of all sizes. 403(b)’s are offered to employees of public schools, charities, some churches and certain tax-exempt organizations, and 457(b)’s are most often available to state and local governments.

The contribution limit for each plan is $19,500 in 2020 and 20201 ($26,000 for those age 50 and over).

Often times, these plans also offer a Roth version. All that means is after-tax dollars are contributed to the plan, as opposed pre-tax dollars. The benefit to Roth elections is that you take the money out tax-free at retirement, which is useful if you’re expecting your tax rate to be higher at retirement than at the time you’re making the contribution.

Briefly, these plans work by the employee contributing pre-tax wages (i.e. contributions are not considered taxable income for that year). The plan allows these contributions to grow tax- free until you withdraw them at retirement. They are taxed at retirement at your tax-rate at that time. So what are the pros and cons to this plan?

Pros:

Cons:

1. any withdrawals that take place before age 59.5 are subject to a 10% penalty and potentially other taxes. Some, but not all, plans allows you take loans from your funds for qualified reasons
2. investments limited to what is available as an investment option in your employer’s chosen program (thus you may not be able to invest in what you want)

Note on the 457(b) plan: These plans are often considered to be a supplemental savings plan, and so withdrawals before age 59.5 are not subject to the 10% penalty. Additionally, this plan offers some special catch-up saving provisions for older workers that the other plans don’t offer. A downside, however, is 457(b)’s don’t typically offer an employer match, and taking that emergency withdrawal (while not penalized) is much more difficult. This plan is most useful for retired public servants who may have a physical disability and need access to their money before aged 59.5.

2. IRA Plans

There are several kinds of IRA plans: traditional IRA, Roth IRA, spousal IRA, rollover IRA, SEP IRA, and SIMPLE IRA. Important to note though is that there are income limits in place for those who can contribute to an IRA plan. If your income is above that limit, a backdoor Roth IRA might be the solution for you. For those within the income limits, you can contribute up to $6,000 in 2020 and 2021, and individuals over age 50 can contribute up to $7,000.

Traditional IRAs

This IRA is available to anyone who wants to contribute pre-tax dollars (i.e. contributions that won’t be considered taxable income for that year). Similar to 401(k)’s and the like, traditional IRAs allow the contributions to grow tax-free until the account holder withdraws them at retirement, and then they become taxable as they’re used. Earlier withdrawals may leave the employee subject to additional taxes and penalties.

Pros:

1. allows you to contribute pre-tax dollars (useful if you’re expecting your tax-rate at retirement to be lower than the tax-rate at contribution)
2. allows you a large variety of assets to invest in (stocks, bonds, CDs, real estate, etc.)

Cons:

1. difficult to withdraw money early due to penalties and taxes
2. required to invest the money yourself (where to invest, what to invest in, etc.) as opposed to automatically investing through your employer’s set program in a 401(k)

Roth IRA

The difference between this Roth IRA and traditional IRA is that contributions to a Roth IRA are made with after-tax money (i.e. you’ve already paid taxes on the contribution that goes into the account). The benefit is that you won’t have to pay tax on any withdrawals that come out of the account at retirement.

Pros:

Spousal IRA

While IRAs are typically for workers who have earned income, through the spousal IRA, the spouse of a worker with earned income can fund an IRA as well. For this IRA, the working spouse’s taxable income must be more than the contributions made to any IRAs. Then your spousal IRA can in the form a traditional IRA or a Roth IRA.

Pros:

1. allows non-working spouse to take advantage of an IRA’s benefits (either traditional or Roth version) opposed to automatically investing through your employer’s set program in a 401(k)

Cons:

1. required to invest the money yourself (where to invest, what to invest in, etc.) as opposed to automatically investing through your employer’s set program in a 401(k)

Rollover IRA

These IRA accounts are created to accommodate the movement of an already existing 401(k) or IRA account to a new IRA account. You can “roll” the money from the existing account to the rollover IRA, and the rollover IRA can be either a traditional IRA or a Roth IRA. There’s no limit to the amount of money that can be transferred into a rollover IRA.

A rollover IRA also allows you to change the type of retirement account, from a traditional IRA to a Roth IRA, or vice versa. It is important to remember that certain types of transfers can create tax liabilities.

Pros:

1. buy a wide variety of instruments
2. transfer funds to different IRA accounts or change IRA providers

Cons:

1. required to invest the money yourself (where to invest, what to invest in, etc.) as opposed to automatically investing through your employer’s set program in a 401(k)
2. be aware of tax consequences for rolling over money (mostly an issue if you’re changing account types – e.g. from traditional to Roth)

SEP IRA

This IRA account is set up like a traditional IRA account, but for small business owners and their employees. Only the employer can contribute to this plan, and the contributions go into a SEP IRA for each employee rather than a trust fund. Self-employed individuals can also set up a SEP IRA.

It is important to note that contribution limits for the SEP IRA in 2020 and 2021 are 25% of compensation OR $57,000 (whichever is less).

Pros:

1. For employees of small businesses, this is an easy to set up retirement account (especially if you want to contribute less than 20% of earnings)
2. For self-employed individuals, the higher contribution limits make them more attractive than a regular IRA
3. Money is more easily accessible than traditional IRA plans

Cons:

1. no certainty around how much employees will accumulate in this plan, as the employer contributes
2. required to invest the money yourself (where to invest, what to invest in, etc.) as opposed to automatically investing through your employer’s set program in a 401(k)
3. can’t set the plan up as a Roth (i.e. using post-tax money)
4. 10% tax penalty for early withdrawal before age 59.5

SIMPLE IRA

With a SIMPLE IRA plan, employers provide the same benefi ts to all employees. The employer can choose to contribute either 3% match or make a 2% non-elective contribution even if the employee saves nothing in his or her own SIMPLE IRA.

Pros:

1. this is more geared towards employer’s perspectives on how they want to structure match elections (i.e. 3% match vs. 2% non-elective contribution)
2. from the employee perspective, not much change from 401(k) plan

Cons:

1. employee contribution limit is $13,500 for 2020 and 2021, compared to $19,500 for other defined contribution plans
2. required to invest the money yourself (where to invest, what to invest in, etc.) as opposed to automatically investing through your employer’s set program in a 401(k)

Solo 401(k) Plan

Also known as a Solo-k, Uni-k, and One-participant k, this plan is designed for a business owner and his or her spouse.

Pros:

1. If you have no other employees, a solo-k is better than a SIMPLE IRA because you can contribute more to it
2. Also, better than a SEP IRA if you want to contribute more than 20% of your earnings
3. Can set your plan as a Roth (can’t do that in a SEP)

Cons:

1. more complicated to set up and terminate than a SEP IRA
2. once assets exceed $250,000, need to file annual report on Form 5500-SE
3. not good if you’re planning to expand and hire employees