Types of Retirement Plans and How They Can Work for You

Did you know that the average American spends roughly 20 years in retirement? While social security benefits will certainly come in handy during this time, you shouldn’t expect to live off of these benefits alone. If you’re envisioning the last decades of your life to be filled with fun and relaxation, you’ll want to start investing now.

One of the first steps to saving for retirement is choosing the right plan.

What to Look for in a Retirement Plan

When investigating retirement plans, think about the following questions:

• What is my time horizon? Will I be retiring in five years or forty years?
• What is my risk tolerance?
• How many investment options would I like to have?
• How much will I realistically need to have in retirement?
• How much will I need to contribute each year to reach that goal?
• Will I be in a higher tax bracket now or in retirement?

Answering these questions can help you narrow down the best plan for you as you look at your options.

How many types of retirement plans are there?

If you find yourself lost looking at all of the retirement benefit options, you’re probably not alone. With over a dozen types of plans to choose from, ranging from the tax-advantaged employer-sponsored 401(k) to investing on your own with an index fund.

The important thing is that you aren’t just saving— you need to be investing. While nothing is stopping you from putting money in a savings account, this wouldn’t be the most effective method. Because of inflation, the money that you save (in an account that doesn’t earn significant interest) is worth less and less each year.

The key is to put your money in an investment vehicle that will outpace inflation, hopefully at a higher rate.

Types of Retirement Plans

The following are some of the most common plans that you can invest in.

IRAs

An individual retirement arrangement (IRA) is one of the most popular retirement plans. With an IRA, you can choose how your money is invested and typically have a wide range of options to choose from. Under the IRA umbrella, there are several types of accounts.

Traditional IRA

A traditional IRA is a type of retirement plan that has immediate tax advantages. It is a tax-deferred investment, meaning that you don’t have to pay taxes on it upfront. Instead, you’ll pay them when you withdraw money from the account in retirement. The taxes you pay will be based upon your marginal tax rate at the time of withdrawal.

Traditional IRA pros:

• Anyone can invest in an IRA
• Lowers your taxable income the years that you contribute

Traditional IRA cons:

• Low contribution limits ($6,000 for 2022)

Roth IRA

Roth IRAs are funded with after-tax earnings, meaning you won’t realize any immediate tax benefits. However, when you withdraw from your account in retirement, both the amount you contributed and your investment gains will be tax-free. This is especially beneficial if you expect a higher tax bracket in retirement than it is when you initially invested the money.

Roth IRA pros:

• Your withdrawals in retirement are tax-free

Roth IRA cons:

• People over a certain income cannot participate
• Low contribution limits ($6,000 for 2022)

SIMPLE IRA

A Savings Incentive Match Plan for Employees— or SIMPLE IRA for short— is an employer-sponsored retirement plan that may be available if your employer has fewer than 100 employees. Both employees and employers can contribute to a SIMPLE IRA, as opposed to a SEP IRA, which only allows employers to contribute.

SIMPLE IRA pros:

• Lowers your taxable income the years that you contribute
• Employees are immediately vested in their employer’s contributions

SIMPLE IRA cons:

• While a SIMPLE IRA has higher contribution limits than an IRA, it has lower limits than a 401(k) plan (For 2022, the contribution limit for employees is $14,000.)

SEP IRA

A simplified employee pension (SEP) is a type of employer-funded IRA that small businesses or self-employed individuals can establish. Sole proprietors, partnerships, and corporations are eligible to participate.

SEP IRA pros:

• Higher contribution limit (For 2022, contributions are limited to the lesser of 25% of pay or $61,000.)
• Employees are immediately vested in employer contributions

SEP IRA cons:

• SEP IRAs are funded by employer contributions, meaning you can’t always control how much is going into your retirement account

401(k) Plans

A 401(k) is an employer-sponsored tax-advantaged retirement plan and another popular option. They are often included in an employer’s benefits package and are available to employees at little or no cost. Employers can elect to contribute to their employees’ 401(k)s by matching the money that they put into their account up to a certain amount.

Contributions to a traditional 401(k) are done “pre-tax”, which means that the money is put into your retirement account before taxes are taken out of your paycheck. Come tax season, this translates to a smaller tax burden. The trade-off is that your withdrawals will be taxed in retirement.

401(k) pros:

• Lowers your taxable income the years that you contribute
• Higher contribution limits than IRAs ($20,500 for 2022)
• Possibility for employer matching
• Easy to set up through your employer

Cons of a 401(k):

• You may have to stay at your company for several years to be eligible for matched contributions
• Investing options are typically more limited

Roth 401(k)

Like an IRA, 401(k) also has a Roth option, which allows you to pay taxes on your contributions but take distributions tax-free.

Solo 401(k)

One-participant 401(k) plans are designed to cover self-employed individuals, freelancers, and business owners that have no employees. These plans are bound to the same rules and requirements as employer-sponsored 401(k)s and function similarly.

403(b) Plans

A 403(b) plan is similar to a 401(k), but instead of being offered to employees of for-profit companies, a 403(b) is offered to non-profit or government employees. Specific employees of public schools, tax-exempt organizations, and certain ministers are eligible for this type of plan.

403(b) plans are comparable to a 401(k) with a few exceptions. For instance, if you have been at your company for fifteen or more years, you may be eligible for extra contributions.

Like a 401(k), a 401(b) has a yearly contribution limit, has a Roth option, and requires that participants reach age 59 ½ before they can withdraw money penalty-free.

Index Funds

Investing in an account specifically designated for retirement isn’t the only way you can save. You can also invest in index funds as a retirement strategy.

An index fund is a type of exchange-traded fund or mutual fund that has a portfolio designed to follow the market. The goal of this type of investment is to provide a diverse, broad market exposure. To invest in an index fund, simply set up an investment account with an investment brokerage or financial institution of your choice.

Pros of investing in an index fund:

• No contribution limits
• Can withdraw money at any age without penalty
• Anyone can invest

Cons of investing in an index fund:

• There are no tax advantages, and you’ll have to pay taxes on your realized gains
• Because there are no early withdrawal penalties, you may be tempted to dip into your retirement funds before you actually retire

Choosing the Right Retirement Plan

With so many choices to choose from, picking the right retirement may feel a little overwhelming. Luckily, it’s not a choice that you have to make alone. While it always helps to do your own research, a financial advisor can be a valuable resource in helping you get on the right track with your retirement savings. At the end of the day, however, the best types of retirement plans are the ones that you put money into!