4 Kinds of Retirement Plans Explained

While planning for retirement, it is important to have clear goals when it comes to identifying income sources in retirement, making a budget, and the amount of savings you need in retirement to live comfortably. You must also have a clear idea about how you are going to manage your assets and risk. It is advised you begin saving for retirement at an early stage in life to give yourself the best shot at building a substantial retirement corpus.

The amount that you need to save for retirement depends on your retirement goals. Some retirees may wish to travel in retirement while others may want to begin a small business venture to supplement their income. You also need to consider other factors such as the age at which you wish to retire, your annual income, risk profile, etc. There are a number of retirement plans that you can choose from based on your unique financial needs and goals. Consider consulting a professional financial advisor who can explain the benefits and drawbacks of different retirement plans, their taxability, and more, and help you choose the most suitable retirement plan for your financial needs.

Read below to understand the different types of retirement plans in detail:

What are the different kinds of retirement plans?

There are various kinds of tax-advantaged retirement plans available that you may consider to save for retirement:

1. 401k

A 401k is a tax-advantaged retirement savings plan offered by employers to their employees. Better known as an employer-sponsored retirement account, there are primarily two kinds of 401ks: a Traditional 401k and a Roth 401k. The primary benefit of a 401k is an employer match wherein the employer may match the employee’s contributions. This can help you build a bigger retirement corpus and boost your savings. The Internal Revenue Service (IRS) sets the contribution limits. For 2022, you can contribute a sum of $20,500 to your 401(k) account. If you are 50 years of age or older, you can contribute an additional $6,500, bringing your total to $27,000. Do note that if you make a withdrawal before reaching 59.5 years of age, the IRS may levy a penalty of 10% on the withdrawn amount.

Traditional 401k:

In a traditional 401k, you make contributions from your pre-tax income which means that your taxable income is reduced by the total amount contributed by you to your 401k for the year. Essentially, you do not have to pay tax in the present but you would have to do so at the time of making withdrawals in retirement. Additionally, you must take out the Required Minimum Distributions (RMDs) when you turn 72. Failure to do so would result in a 50% penalty on the amount not withdrawn by you.

Roth 401k

Contrary to a traditional 401k, you make contributions to a Roth 401k account from your after-tax dollars. This means you have to pay taxes on your taxable income in the present. However, you can make tax-free withdrawals in retirement provided you are 59.5 years of age and have held your account for a period of at least five years. Moreover, you do not have to take mandatory RMDs if you hold a Roth 401k plan.

2. Individual Retirement Account (IRA)

An IRA is a tax-advantaged retirement savings plan that can be opened by self-employed individuals who do not have access to a 401k. You can open an IRA through a bank, an online brokerage, a mutual fund house, an insurance company, or a broker. You cannot make a withdrawal before you turn 59.5. If you do so, you will incur a penalty of 10% on the withdrawn amount. For 2022, you can contribute a sum of $6000 and make an additional catch-up contribution of $1000 if you are 50 and up to your IRA account.  There are several kinds of IRAs such as:

Traditional IRA:

In this retirement plan, your money grows on a tax-deferred basis. Your contributions are tax-deductible i.e. you make contributions from your pre-tax dollars. However, you will have to pay tax on your withdrawals in retirement as per the prevalent tax rates. In addition, similar to traditional 401ks, you must take out RMDs when you reach 72 years of age. You also have the option of converting your traditional IRA to a Roth IRA account if you expect to be in a higher tax bracket in retirement.

Roth IRA:

Unlike a traditional IRA, you make contributions to a Roth IRA account from your after-tax income. This means your contributions are not tax-deductible. However, you will be able to make tax-free withdrawals in retirement provided 5 years have passed since you opened your account and you are 59.5 years of age. Additionally, you are not required to take out RMDs in a Roth IRA account. You have a wide range of investment options available to you to invest in such as mutual funds, bonds, money market funds, exchange-traded funds (ETFs), stocks, certificates of deposit (CDs), cryptocurrency, and more.

SEP-IRA:

A Simplified Employee Pension (SEP) is a retirement plan especially designed for self-employed individuals like small-business owners, independent contractors, and freelancers. It follows the same tax rules for withdrawals as that of a traditional IRA. For 2022, a maximum of $61,000 or 25% of compensation, whichever is less can be contributed to the SEP-IRA account. Employees cannot contribute to their accounts meaning business owners must do so on their behalf.

SIMPLE IRA:

Savings Incentive Match Plan for Employees IRA is a retirement account available to small businesses having 100 or fewer employees. Contributions to a SIMPLE IRA are tax-deductible in nature and follow the same tax rules for withdrawals as a traditional IRA. Unlike a SEP-IRA, employees can make contributions to their SIMPLE IRA accounts. For 2022, you can contribute a maximum of $14,000 along with a catch-up contribution of $3,000 (if you are 50 and up), bringing your total to $17,000 for the year.

Spousal IRA:

Created for married couples, in a spousal IRA a working spouse can make contributions to an IRA on behalf of their non-working spouse. Herein, the non-working spouse can open a traditional or Roth IRA in their own name despite having little to no income. However, to qualify for spousal IRA contributions, the couple must file a joint tax return. Moreover, in order for the working spouse to contribute on behalf of both spouses, their income must be equal to or exceed the total IRA contributions made by them. For 2022, married couples can contribute a sum of $12,000 to their IRAs. However, if you are both 50 and up, you can contribute an additional $2,000, bringing the total to $14,000.

SPONSORED WISERADVISOR

3. Thrift savings plan (TSP)

Created for federal employees and uniformed service personnel, a TSP is a retirement investment program similar to a 401k plan. It offers multiple benefits such as automatic payroll transfers, agency matching contributions, etc. For 2022, you can contribute a sum of $20,500 and make an additional catch-up contribution of $6,500, if you are 50 years of age or older. If you have started a federal government job, you can move your 401k and IRA to a TSP and vice versa if you end up changing your job.

4. Cash-balance pension plans

A cash-balance plan offers participants a set percentage of their yearly compensation plus interest charges. It is similar to a defined-benefit pension plan wherein you have the option of a lifetime annuity. The primary benefit of a cash-balance plan is that contribution limits increase with age. For instance, if you are 60 or up, you can save more than $200,000 per year in pretax contributions.

To summarize

Based on your financial needs and goals, annual income, employment status, and more, you can invest in a number of retirement plans. You can go for a company-sponsored retirement plan such as a 401k or start one yourself like an IRA. Though each plan may have different benefits and drawbacks, you can rest assured that it will help you save for retirement and build a substantial retirement corpus. It is advised that you begin saving for retirement as soon as possible due to rising inflation and depleting benefits of Social Security programs.

Reach out to a professional financial advisor in your area who will be able to explain different types of retirement plans, their pros and cons, taxability, contribution limits, and more. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.