Setting the record straight: Retirement accounts
Retirement planning is one of the most fundamental parts of our job. In order to build you the best possible plan, we want you to understand the basics of the different types of retirement accounts. This can help you share information with us. It can also help you understand the “how” and “why” of the plan we build for you.
Before we get started, keep in mind that there are a few things that hold true for nearly all retirement accounts:
- Your earnings grow tax free (as in, no capital gains tax).
- They come with early withdrawal provisions or penalties.
- There are limits to how much you can contribute each year.
We aren’t going to spend too much time on contribution limits in this article, since they change each year and often vary based on age and circumstance. However, we’ll discuss these in detail when we create your individual plan, and you can always look them up on the IRS website.
(If you work for yourself or own a business, skip to the final section. You have more flexibility in the type of plan you can create and the amount of money you can set aside.)
A 401(k) is a tax-advantaged, employer-sponsored defined contribution retirement account. Let’s start by breaking down what all those terms mean.
A 401(k) is tax advantaged because money you contribute isn’t subject to income-tax. Any gains on your investments accrue tax-free. Eventually, when you withdraw the money, it will be subject to income tax. (Keep in mind your income-tax rate in retirement may be different than your income tax rate right now.)
401(k)s are sponsored by an employer. They are defined contribution, meaning the amount you receive in retirement is defined by the contributions you make. They’re also self-determined, so you choose how your money is invested. However, you have to choose from the selection of investments offered in your specific plan. (The investment selections in your 401(k) plan are determined by the plan sponsor, or your employer.)
In addition to how 401(k)s work, it’s important for clients to know about employer matches. Many employers offer to match employee contributions up to a certain amount, which is tantamount to additional income for you. Not only that, those employer matches have the potential to grow and compound over time.
If you have questions about the investment options in your plan, which to select, or how to handle an employer match, make note of them so we can address them in our next meeting.
403(b), 401(a)s, 457s, and TSPs
A 401(k) is called a 401(k) because that’s the section of tax code it falls under. Not surprisingly, many of the other, often similar, retirement accounts are also named after their section of tax code. Many of these operate similarly to a 401(k), but are designed for employees of governments, government agencies, or non-profits (as opposed to private companies). We’ll cover these plans at a high level and focus on how they differ from 401(k)s.
- 403(b)s can be offered to public school, government, and nonprofit employees. They started out as different from a 401(k) but these days operate in a very similar way and with the same annual contribution limits. There are some differences when it comes to catchup contributions and employer matches, and you can always check with the IRS for the most up-to-date details.
There are two types of 457 plans, a 457(b) and a 457(f). Both carry unique rules:
- 457(b) plans are unique in that you don’t need to wait until you’re 59½ to access your benefits, they become available as soon as you no longer work for the employer. That means you can take deductions prior to retirement age with no penalties.
- 457(f) plans aren’t particularly common and are primarily used to recruit high-level executives to nonprofit jobs. With 457(f) plans, your entire compensation can be tax-deferred, but you must wait two years to access those earnings, and if you leave the job, you could forfeit them.
Next, we’ll look at 401(a)s and the Thrift Savings Plan (TSP).
- 401(a) plans may be available to government, education, and nonprofit workers. 401(a) plans differ from 401(k)s in that employees don’t contribute; instead, employers contribute to these plans. The employer decides whether these are mandatory or voluntary, pre-tax or after-tax, and a set amount or a percentage of employee pay. Investment options tend to be limited and employees cannot transfer funds into a new account if they leave the employer.
- Thrift Savings Plans (TSPs) are unique to the military and federal government employees. The most noteworthy aspect of the TSP is its incredibly low fees: roughly 38 cents for every $1,000 invested. While the investment choices may be limited, the incredibly low fees are a big pro, particularly when you consider the compounding effects.
Individual retirement accounts are more commonly referred to by their acronym: IRA. These are tax-advantaged investing accounts intended to help you build a retirement nest egg. IRAs are not tied to your employer, like the plans we’ve discussed up to this point. They are self-directed and tax-advantaged, and there are many different types.
Traditional IRAs are similar to 401(k)s in that you do not pay taxes on the money you contribute right now. However, you’ll pay income taxes on the money when you withdraw it in retirement. Any adult, regardless of employment status, can open and contribute to an IRA, however the IRS sets limits on how much pre-tax income you can contribute to an IRA each year.
ROTH IRAs are set up differently: You contribute after-tax dollars and when you withdraw the money in retirement, it’s not subject to federal income tax. Roth accounts have some additional benefits: you can access your principal investment after a waiting period, and required minimum distributions (RMDs) are waived. However, if your income is higher than a certain amount, you may not be eligible to contribute directly to a Roth account. (If this is the case, and you still wish to contribute to a Roth, you may be able to use a rollover. This is something we can discuss in our next meeting.)
Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax.
If you’re self-employed or own a business
There are a handful of accounts designed specifically for self-employed workers, and we’ll start with those, then move on to plan options if your business grows to include additional employees.
Solo 401(k)s are like 401(k)s but designed for the self-employed business owner who works solo, as the name implies. If you have employees, you don’t qualify. You can open a solo 401(k) through a brokerage or advisor using an EIN and make contributions as both yourself, and your employee to maximize your tax-advantaged contributions. Keep in mind, if you are contributing to another 401(k) — via a second job, for instance — your combined contributions to both plans must stay below the IRS’s yearly contribution limits.
SEP IRAs work the same as traditional IRAs, but they are designed specifically for self-employed Americans. SEP stands for simplified employee pension. The contribution limits are higher for SEP IRAs than traditional IRAs, since a self-employed person doesn’t have access to a 401(k) or traditional pension plan sponsored by a company.
SIMPLE IRAs are similar to SEP IRAs, except in these plans, employees can contribute to the plan as well. SIMPLE stands for Savings Incentive Match Plan for Employees of Small Employers. That also means that, like with a solo 401(k), you can contribute as both the employer AND the employee which could offer tax advantages. As you hire employees (up to 100), you can set up IRAs for each under your SIMPLE plan, which both you (as the employer) and they (as employees) can contribute to. Check with the IRS for the most up-to-date limits and rules.
As a small business owner, you can also build 401(k) or pension plans for your employees, which could offer tax benefits to you and your business. You could use one of the plans outlined above as a base, or you might create a plan that’s structured like a more classic corporate 401(k). What works best will depend on the structure of your business, number of employees, and plans for growth. These are all things we can work with you on.
This is by no means a comprehensive list of all the retirement plan options available, but it covers the main plans that we see most frequently, and that you’ll hear discussed in financial advice blogs or on the news. As you can see, these accounts all come with different rules and reasons why you might prefer one type of account over another
One of the biggest benefits we offer as advisors is help navigating these plans. We can discuss which accounts to prioritize to how to select investments within each account. If you want to discuss your current accounts or retirement planning in general, make an appointment and let’s discuss.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.