At a high level all retirement accounts may seem like the same thing - you put money away each paycheck and years down the line you get a nice pile of your savings, plus some added interest. But if you look beneath the surface there are actually a wide range of retirement savings accounts, each with its own unique set of benefits and drawbacks. While you should consult a tax or investment professional before making any decisions regarding your retirement savings, the below should give you a good sense of the most popular types of retirement accounts.

Traditional IRA

One of the most common forms of retirement account is the Individual Retirement Account, or IRA. As we explain in further detail below there are actually several different types of IRA: the traditional IRA, the Roth IRA, the SEP IRA, and a SIMPLE IRA.

The main benefit of an IRA is that it allows you to save money for retirement in a manner that brings several tax benefits. Specifically, with a traditional IRA your contributions that you make to your account are generally tax deductible. We say generally because your IRA contributions are only fully deductible if you don’t have a retirement plan at work - if you or your spouse have a retirement plan like a 401(k) or 403(b) - then your IRA contributions will not be fully deductible. But if you don’t have such a plan then your contributions are deductible, meaning that if during the year you contribute $5,000 to your IRA, then you will be able to deduct $5,000 from your taxable income for the year.  The amount that you can contribute each year is capped - for the years 2021 and 2022 the limit is $6,000 per year, unless you are over 50, in which case you can contribute $7,000 per year. The main benefit of this, along with the yearly deduction, is that your money will grow on a tax deferred basis.  

It is not until you withdraw the money in retirement that you are taxed at your ordinary income tax rate. However, if you withdraw your savings before the age of 59 ½ you will incur an additional 10% penalty, unless you fall into one of the enumerated exceptions such as a first-time house purchase.‍

Roth IRA

A Roth IRA is in many ways the inverse of a traditional IRA. While with a traditional IRA your contributions are tax deductible, contributions to a Roth IRA are not tax deductible but your qualified distributions (in other words, the money you eventually receive from your account) are tax-free. In other words, with a Roth IRA you are contributing post-tax dollars, but when you do finally withdraw your money that withdrawal will be tax-free. Whether you should use a traditional IRA or a Roth IRA is a question for a financial advisor, but at a high level the decision is based upon your tax bracket, the expected tax rate when you plan to retire, and your own personal preferences. If you expect to be in a higher tax bracket when you retire than you are currently in, then a Roth IRA might make the most sense for you as you will avoid paying taxes when you withdraw the funds upon retirement. It’s for this reason that often times younger and lower-income workers see the most benefits from opening a Roth IRA.

SEP IRA

The SEP in SEP IRA stands for “Simplified Employee Pension”, and is designed, as you can probably guess from the name, for self-employed individuals like independent contractors or freelancers, and small-business owners. However, while SEP IRA’s are generally set up by self-employed individuals for themselves, business owners may set up SEP IRA’s for their employees and deduct these contributions from their own taxes (but the employees themselves may not contribute to these plans). Withdrawal rules for SEP IRA’s mirror those of traditional IRA’s, but have a different contribution threshold. In 2022 the SEP IRA contribution threshold was the lesser value of either 25% of an individual’s compensation or $61,000.‍

SIMPLE IRA

You may have heard the term “SIMPLE IRA” before and thought that it was just someone referring to a traditional IRA by another name, but SIMPLE is in fact an acronym, standing for “Savings Incentive Match Plan for Employees.” Like the SEP IRA the SIMPLE IRA is designed for small businesses and the self-employed and also follows the withdrawal rules of the traditional IRA. Where the SIMPLE IRA differs from the SEP IRA is that employers are required to make contributions, and employees are also allowed to make contributions, all of which are tax deductible. For 2022, the employee contribution limit is $14,000, and $17,000 for workers age 50 and above.

401(k)

Along with the traditional IRA, the 401(k) is probably the most well-known type of retirement account. Named after Section 401(k) of the Internal Revenue Code (or title 26 of the U.S. Code for all your lawyers following along at home), the 401(k) is offered by many U.S. employers and involves employees signing up to have a percentage of every paycheck paid directly into an investment account, with the employee getting to choose a variety of investment options for that money (with the options generally being mutual funds). A common perk provided by employers is that they will “match” the contributions you make to your retirement.

Like IRA’s, 401(k)’s are also broken down into traditional 401(k)’s and Roth 401(k)’s, with the two types of accounts keeping their traditional breakdown that's explained above. So with a 401(k) the employee’s contributions are made “pre-tax”, meaning that they reduce taxable income, but that the withdrawal is then taxed. On the other hand, with a Roth 401(k) the contributions are made with after tax income, meaning that while there are no tax deductions the year that you make your contributions, on the back-end the withdrawals are made tax free. Furthermore there are contribution limits to 401(k)’s just like with IRA’s. For 2022 the limit for a person under 50 was $20,500 and $27,000 for someone aged 50 or above. And again like IRA’s, 401(k)’s are designed to only be withdrawn from upon retirement. Therefore, to take money out of a 401(k) you must generally be at least 59 ½ or otherwise face a 10% early-distribution tax, on top of the additional taxes that may be owed.  To learn more about withdrawing money from your 401(k), check out our blog post on the topic here.

A final wrinkle to the 401(k) is what’s known as the Required Minimum Distribution, or RMD. This is a requirement that 401(k) holders make a minimum required distribution from their account upon reaching a certain age (currently that age is 72). Upon reaching this age, individuals must withdraw at least a certain amount of their 401(k) plan as specified by IRS tables based on life expectancy.‍

401(a)

A similar sounding (and similar operating) retirement account option is provided by a 401(a). Like a 401(k), the 401(a) is an employer-sponsored plan and is usually available to government workers and employees of specified nonprofits and educational institutions. With a 401(a) the employer is required to make contributions (unlike a 401(k)), while employee contributions are only voluntary but are capped at 25% of the employee’s income.  ‍

403(b)

Another variation on the 401(k) is the 403(b), which is designed for employees of specified tax-exempt organizations like public school teachers, church employees, or employees of tax-exempt 501(c)(3) organizations. These plans are incredibly similar to a 401(k), and allow employees to save for retirement through payroll deductions taken by their employer, with the same yearly contribution caps as the 401(k). Also, and stop us if you’ve heard this before, but the 403(b) comes in both traditional and Roth versions (with the same broad breakdown of traditional being pre-tax and Roth being post-tax).  

The 403(b) has certain benefits when compared against the 401(k). First, 403(b) plans are often not subject to the stringent requirements imposed on other retirement plans by the Employee Retirement Income Security Act, known as ERISA, and therefore can come with lower administrative costs, which can help pass savings back to the retiree. In addition many 403(b) plans have a shorter vest period and some even allow for immediate vesting (the vesting period refers to the amount of time an employee will have to work for an organization before they are fully entitled to the employer’s contributions upon the employee leaving the company). Finally, certain employees with 15 or more years of employment at their particular organization may be eligible to make larger contributions towards their retirement. On the other hand, 403(b) plans often have a more limited choice of investment options compared to 401(k) plans.

Whatever your age, it’s never too soon to think about saving for your retirement. And while you should always consult a financial or retirement professional, a great first start is always to research all the possible options.    

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