I believe in living for today, but also saving for tomorrow- so I can continue to live the way I want throughout my retirement. Life is expensive. If you want to continue to afford the things which bring you pleasure and stability, it’s essential to save intelligently.
There is no substitute for time and compounding returns when it comes to building wealth. Retirement plans allow for tax-deferred growth on your money, so saving early and deciding which retirement plan is best for you can be the difference between hundreds of thousands or millions of dollars.
Not all retirement plans are created equal, and your specific circumstances may make you eligible for only certain plans. Furthermore, there are many choices – Traditional or Roth plans, 401(k) or IRA, and even more complicated options if you are self-employed or a small business owner.
I personally use several types of retirement plans. In this article, I will break down all your retirement account choices and then help you determine which retirement plan is best for you.
What is a Retirement Plan?
Retirement plans are tax-advantaged savings plans that allow for your money’s accelerated growth. Almost all types of retirement plans will enable you to invest in various assets without incurring any capital gains taxes for many years while you save for retirement.
How Do Retirement Accounts Work?
Retirement accounts always allow your money to grow tax-deferred, but additional tax benefits exist depending on which account type you choose.
One account style lets you take an immediate tax deduction on your contribution. The second option allows you to defer all future taxes. The two different styles of retirement accounts are known as Traditional plans and Roth plans.
Traditional plans allow savers to reduce their taxes by taking a dollar-for-dollar tax deduction against their income. Traditional account contributions are referred to as pre-tax dollars, because you are investing with money that will not be taxed. Traditional plans will continue to grow until retirement with tax-deferred status. However, account holders must withdraw their investments in annual installments at retirement and then pay ordinary income taxes.
Because you will be required to pay taxes in the future, tax advisors recommend a Traditional style account if you believe you will be in a lower tax bracket at retirement than today.
Those who use Roth plans make their contributions with post-tax dollars, so there is no immediate tax deduction. However, Roth accounts are never taxed again as long as you satisfy the age requirement (59½ +) and hold the account for a minimum of five years (Roth IRA restriction).
The most common question I get about retirement accounts is choosing between Traditional vs. Roth accounts. This decision will be analyzed and covered below.
Retirement Accounts Offered By Employers
There are several different types of retirement accounts offered by companies to help their employees save for retirement.
Most plans offered today are known as defined contribution plans, meaning you choose how much you want to put into the account, either as a fixed dollar amount or a percentage of your paychecks. In a defined contribution plan, you will need to decide how to allocate your investments.
In some industries, defined benefit plans (also known as pension plans) may be an option that guarantees regular payments upon retirement. Pension plans are less common in private industry than they were in the past. Each pension plan is unique, so you should evaluate your defined benefit plan on a case-by-case basis.
Let’s dive into the standardized types of defined contribution plans and compare the details.
*Maximum employer contributions are at the discretion of individual companies. Most employers offer matching contributions or profiting sharing policies which may or may not reach the maximum allowed limits set by the IRS.
*For SIMPLE IRA employer contributions, employers must choose and apply one of the following matching contribution methods for all employee participants (including yourself if you are the business owner).
- Either match 2% of each employee’s total compensation (up to $330,000 for 2023).
- Or, dollar-for-dollar match each employee’s contributions up to 3% of their salary.
401(k) plans are the most common type of company-sponsored retirement plan. 401(k)s can be offered as either Traditional or Roth-styled accounts. The Roth 401(k) is now available for most participants and is not restricted by income level (unlike the Roth IRA).
401(k) plans often have limited investment options- usually several mutual funds and target date funds. I suggest you choose a portfolio of three to four mutual funds that align with your investment plan.
401(k) contribution limits are updated annually by the IRS.
401(k) plans enjoy high contribution limits and employer-match benefits. Most firms offer a form of matching contribution- free money if you contribute a specified amount. You should always take full advantage of the maximum match your company provides.
A 401(k) is the gold standard retirement plan for regular employees. Always contribute enough to get the full company match. I recommend contributing more to your 401(k) if you have the funds available, as this is the most tax-efficient saving account at your disposal.
Some 401(k) plans have higher maintenance or account fees than non-company-sponsored plans, such as IRAs. If these fees are significant, you should consider rolling your 401(k) to an IRA if you leave your company.
401(k) plans have penalties for early withdrawals before age 59 ½.
Solo 401(k) Plans
Solo 401(k) plans (also known as Individual 401(k) plans) are only allowed if you are self-employed. To qualify for a Solo-k plan, your business cannot have any employees besides yourself.
There is one employee exception- if your spouse works for you. In this circumstance, you can contribute to a Solo-k for yourself and your spouse.
Top Dollar Edge: If you are (1) self-employed, (2) the sole earner in your household, and (3) a high-income earner, you should consider ‘hiring’ your spouse and setting up a Solo 401(k) plan for both of you. Your contribution to your spouse’s Solo 401(k) will allow you to double your household’s contributions. There is even a Roth Solo 401(k) option.
Contribution limits are similar to 401(k) plans. But you can act as both an ‘employee’ and ‘employer’ to achieve the maximum contribution limits.
For your “employee” contribution, you can contribute up to 100% of your income (up to the maximum employee contribution limit). For your “employer” contribution, you can contribute up to 25% of your income (up to the maximum employer contribution limit).
There is also an option to contribute to a Roth Solo 401(k) plan, effectively the same benefits as a Roth 401(k).
A Solo 401(k) plan is the preferred account for self-employed individuals with no additional employees.
SIMPLE IRA Plans
SIMPLE IRA plans have standardized matching rules for employers to follow, hence the name (Savings Incentive Match Plans for Employees). Employers are required to follow one of the two SIMPLE matching rules:
- Either match 2% of each employee’s compensation (up to $330,000 for 2023).
- Or, dollar-for-dollar match each employee’s contributions up to 3% of their salary.
For example, if an employee made $250,000 and contributed the maximum ($15,500) to their SIMPLE IRA, the employer would either have to match $5,000 (2% x $250,000) or $7,500 (3% x $250,000, max at $15,500). The match amount depends on which rule they are using. The rule must be made clear to employees and applied company-wide to everyone in the plan.
Employers can lower the percentage match option from 3% to 1%, but they must notify plan participants 60 days in advance and may only do this for 2 out of every 5 years.
Simple IRA plans are meant for small businesses with less than 100 employees. These contributions are always made with pre-tax dollars. There is no Roth option for a SIMPLE IRA plan.
SIMPLE contribution limits for the 2023 tax year are capped at $15,500 for individual contributions. In addition, there is a $3,500 catchup contribution for individuals aged 50 years or older.
Whereas some company retirement plans have vesting schedules for employer contributions, SIMPLE IRAs are always 100% vested.
SIMPLE plans have lower limits than other company-sponsored plans. However, SIMPLE IRA plans are still preferable to individual retirement accounts (IRAs) because there is still a match benefit. Furthermore, employees can still contribute to an IRA in addition to a SIMPLE plan.
SEP IRA Plans
SEP (Simplified employee pension) plans are for small businesses or self-employed individuals. In a SEP, the employer makes all the contributions on behalf of the employees, and can deduct contributions from company earnings. This is a way for a small business to contribute directly to a retirement account on behalf of its employees.
Although the SEP plan is an IRA, the maximum limits replicate those of the 401(k) plan. Employers can make a total contribution equal to the combined limits of the employee and employer 401(k) limits, $66,000 in 2023. Individual employees cannot contribute on their own.
Contributions cannot exceed 25% of an employee’s compensation, so if your salary is $200,000, the max contribution is capped at $50,000.
If you are a business owner, you can choose how and when to make SEP contributions. Contributions do not have to be made annually. However, when contributions are made, they must be applied equally to each employee. For example, if you want to contribute 15% of your annual income to the plan, you must contribute15% of each employee’s income into their SEP accounts as well.
SEP IRAs are generally the easiest self-employed retirement plan to manage in terms of paperwork and annual tax reporting.
If you are self-employed, a SEP offers many of the same advantages as a Solo 401(k). The only reason to choose the SEP would be because you have employees.
403(b) and 457(b) and Thrift Savings Plans
403(b) and 457(b) plans are offered for state and local government workers or certain tax-exempt organizations or non-profits. Thrift Savings Plans are comparable to 401(k) plans for federal government employees.
These plans can are offered as Traditional accounts or Roth accounts. Individual contribution limits are similar to 401(k) contributions, but the 457(b) plan does not include the increased employer contribution limits.
457(b) plans do not allow for additional employer limits. In the event that an employer offers its own contribution, the total contribution per year (for employer and employer combined) is capped at the individual limit of the 401(k).
403(b) plans usually have the least investment options. The IRS has more stringent options for these types of accounts, only allowing certain types of annuities and mutual funds.
Retirement Accounts Unrelated To Your Employer
What if your employer does not offer a retirement plan, or you’re in between jobs? In this case, you can contribute to an individual retirement account.
A Traditional IRA is fully managed by you. Similar to all other Traditional accounts, contributions are made with pre-tax dollars and are tax-deductible up to the annual limit if you are non-covered by an employer plan.
Note that the limits are significantly lower for IRA contributions than for company-sponsored plans, and you do not receive any form of a match from your employer.
IRAs are also useful for consolidating multiple retirement accounts. These types of IRAs (called ‘rollover IRAs’) are no different than regular IRAs, but are funded with “rolled over” funds from either another IRA or 401(k).
If you leave your job, consider rolling your 401(k) into an IRA. Benefits often include lower fees, more investment options, and simplicity (maintaining fewer accounts).
IRA funds need to remain in your account until age 59 ½. Withdrawing earlier will incur a 10% penalty, and is not recommended. IRA rules mandate withdrawals starting at age 72 (called required minimum distributions, or RMDs).
Although contributions are initially tax deductible and the earnings grow tax-free, withdrawals of both principal and earnings are taxed at ordinary income rates at retirement.
A Roth IRA is an alternative option for an individually managed account.
Contributions are made with post-tax dollars and are not tax-deductible. Limits are the same as for a Traditional IRA.
Contributions to a Roth IRA are limited to those making under certain income limits. If you are under the income limits, you can contribute to a Roth IRA in addition to any company-sponsored plan you participate in.
If you have enough free cash available to contribute to both your company-sponsored plan and a Roth IRA, you should do so. You can always access the contribution without penalty or taxes if you need the money for an emergency.
Funds within your Roth IRA should be kept until age 59 ½ to avoid taxes or penalties. To qualify to withdraw all funds without incurring taxes on your earnings, you need to have the account opened for at least 5-years in addition to the age requirement.
However, Roth IRAs always allow you to withdraw any contributions (but not earnings) without penalty or taxes.
There are no required minimum distributions for Roth IRAs, making them extra valuable for estate planning and tax-deferred growth into late retirement.
Can You Contribute To An Employer Plan and an IRA?
If you are covered by a company-sponsored plan (such as a 401(k)), can you still contribute to an IRA? Yes, you can. But, your contribution will most likely not be tax deductible.
If you are over these limits, you can still contribute to a Traditional IRA, but your contributions will not be tax deductible. However, there are still benefits to contributing to a Traditional IRA even if it’s not deductible:
Remember, if you are under the allowed income threshold for a Roth IRA, you can always directly contribute to a Roth account in addition to your company retirement account.
Traditional vs. Roth: Which Style is Better For You?
When analyzing a Traditional vs. Roth account, the same logic applies to both 401(k) or IRA comparisons. The only extra benefit of the Roth IRA is the lack of required minimum distributions (RMDs). However, you can always roll your Roth 401(k) to a Roth IRA (before retirement) with no significant restrictions or tax implications. In fact, I highly recommend rolling for lower costs and more investment options whenever possible, such as if you switch jobs.
*Spoiler alert: The Roth 401(k) or Roth IRA is generally the better option for most individual circumstances.
The only exception occurs if you are making just enough income to put you into the top marginal tax bracket and you believe at some window in the future that you will be in a lower tax bracket. We’ll examine this situation below for group #2.
#1: Highest Income Earners
If you are in the top 1% (which is a household income of $600k+ per year), you are likely maxing out your retirement account and looking for maximum tax saving opportunities. If you are not maxing your retirement plans, you need to take a second look at your finances and make a better financial plan.
I recommend a Roth account for this group because it offers the opportunity to put more money away for retirement annually. This is possible because contributions are made with post-tax dollars, so you are able to save more than if you contributed to an account with pre-tax dollars.
Furthermore, if you are a top-tier income earner, there is a good chance you will still be in a high income tax bracket at retirement (with passive income and social security). If this is likely, a Roth IRA can allow your money to grow into the future without any required minimum distributions. This can allow your savings to continue growing tax-deferred and can be a useful estate planning tool.
#2: High-Income Earners
If you are at (or near) the top tax bracket, but believe you may be in a significantly lower bracket at retirement, your account decision is the most difficult.
In this circumstance, you need to consider if there will be a window at or before retirement when you’ll be in a lower bracket. If this opportunity is possible or likely, then it is better to take the tax deduction today (while you are in the high bracket) and roll the account into a Roth (and pay tax) when you are in the lower tax window. Alternatively, you can not roll the account and pay ordinary taxes at retirement.
Traditional accounts require minimum distributions that you will have to draw and pay tax on every year at retirement. This is not ideal if you don’t need the entire RMD for future living costs, but it can be acceptable if you are in a significantly lower bracket.
I have written an article to analyze your decision.
If you are still unsure what to do, but are currently in the top federal tax bracket and in a high-income tax (such as NY or California), I would recommend contributing to the Traditional account. This is because your downside is minimal if you are already paying tax at or near the highest rates. In the future, you may be presented with an opportunity to roll into a Roth (such as in between jobs or if moving to a lower tax state).
However, if you would like to maximize your retirement savings, then I would recommend considering the Roth because your after-tax dollar contribution will be more considerable.
#3: Average or Lower-Income Earners
If your marginal tax rate (the highest bracket you pay tax) is not near the top rates, the benefits of the tax deduction will pale in comparison to the benefits of the Roth account. The Roth offers tax-free growth and tax-free withdrawals at retirement, which is worth more over your lifetime than a deduction at a lower marginal tax bracket today.
Whether you believe you may be in a higher tax bracket in the future or not, the Roth is still the best option while you are in a lower tax bracket. I always recommend new graduates and career starters to contribute to a Roth 401(k) or a Roth IRA.
Which Type of Retirement Plan Is Best For You?
Company-sponsored retirement plans usually have three benefits over individual retirement accounts:
Retirement accounts are the most tax-efficient tools available for building wealth. Therefore larger contribution limits are preferred if you are trying to maximize your savings.
Matching contributions are free dollars your employer makes into your account when you contribute to your 401(k) plan. You should always contribute enough to take full advantage of the match.
Roth 401(k)s have become increasingly available, and most company plans now offer these accounts. Even better is that there are no income limits for Roth 401(k) contributions. If the Roth account seems like the best option for you, don’t second guess yourself- a Roth 401(k) is a great choice.
If you do choose a Roth 401(k) you’ll want to roll the account to a Roth IRA at some point in the future before retirement. Don’t worry, there are no tax implications when doing this. The main reason to roll is that a Roth IRA does not require minimum distributions, so your savings will grow more effectively in your retirement years. I recommend rolling if you change or leave your job.
Top Dollar Edge: Additionally, if you are looking to put even more away for retirement, you can always make a backdoor Roth contribution in addition to a company-sponsored plan. An individual eligible for a company-sponsored plan is still allowed to make a nondeductible IRA contribution, which is the first step for a backdoor Roth strategy.
Have any questions or comments? Feel free to contact me.
Josh is a financial expert with over 15 years of experience on Wall Street as a senior market strategist and trader. His career has spanned from working on the New York Stock Exchange floor to investment management and portfolio trading at Citibank, Chicago Trading Company, and Flow Traders.
Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business. He has held multiple professional licenses during his career, including FINRA Series 3, 7, 24, 55, Nasdaq OMX, Xetra & Eurex (German), and SIX (Swiss) trading licenses. Josh served as a senior trader and strategist, business partner, and head of futures in his former roles on Wall Street.
Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh currently holds areas of expertise in investing, wealth management, capital markets, taxes, real estate, cryptocurrencies, and personal finance.
Josh currently runs a wealth management business and investment firm. Additionally, he is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses professionally.