Retirement Accounts: A Comprehensive Guide

School of Saving and Investing

A desk with a calculator, glasses, money and 3 blocks with IRA, 401k and ROTH written on them. These are meant to represent a guide to the many different kinds of retirement plans.

The multitude of account options make planning for retirement more difficult. That’s because deciding which plan matches your situation involves comparing plan eligibility, benefits, and tax scenarios.

If you choose the type of retirement account that matches your situation, you will have a better chance of meeting your goals. To make sure you choose wisely, it’s critical to understand the details surrounding each type of account.

What is special about retirement accounts and what are the different types?

Retirement accounts are special because they are intended to provide individuals with a tax-advantaged way to save for retirement. Because of these tax benefits, those who take advantage of retirement accounts can save huge sums of tax money over the life of their investments.

Again, there are many different types of retirement accounts, but they can be broken into two main categories: Defined Benefit Plans and Defined Contribution Plans. The benefits and eligibility for each type of account can vary, so it’s important to know the details to ensure you are selecting the best account for your situation.

Defined Benefit Plans

Defined Benefit Plans are employer sponsored retirement plans that provide a benefit at retirement – most commonly a fixed dollar amount paid monthly. The most common type of Defined Benefit Plan is a pension, but we will also consider Social Security in this section, as it shares many key features of Defined Benefit Plans. With these plans, the benefit amount can vary based on many factors like length of employment and salary.

Defined Benefit Plans are managed by your employer – or the Federal Government in the case of Social Security – and income from these plans is guaranteed regardless of the economy or investment returns. Early withdrawals are usually not allowed but loans are sometimes permitted – depending on the plan. There are two key types of defined benefit plans that you should understand – pensions and Social Security.

Pension Plans

A Traditional Pension plan has historically been the most common type of Defined Benefit Plan provided by employers, but their popularity has waned in recent decades. A pension involves an employer making contributions to an account for future payments to employees. The funds are deposited and invested by the employer to provide predictable income for employees during retirement.

Who’s Eligible

Pensions are available to employees of companies offering this retirement benefit – based on company-specific criteria. The criteria for eligibility can be based on a combination of factors like an employee’s salary, length of employment, and age at retirement.

Benefits & Limitations

Enrollment into a pension plan often occurs after an initial period of employment – usually at least a year. A pension will provide a set income amount at retirement, which helps you budget current and future spending. One of the major benefits of pension is the payments will remain stable in a changing economy.

Pension contributions are typically made by the employer and do not provide tax benefits to the employee. Payments are taxable to the employee when received during retirement. These plans allow employers to deposit and deduct higher annual amounts than other types of plans. This can allow for substantial retirement savings to be accumulated in a short period of time. Vesting – the transfer of ownership from the employer to the employee – can be immediate, or it can be stratified up to seven years.

With pension plans, you have no control over your employer’s investment decisions. These decisions are made by the company with the intention of meeting the needs of the entire plan – rather than each individual employee. Pensions do not allow for withdrawals before the age of 59 1/2, although some pension programs do offer loan options. Pensions require significant oversight and maintenance, and they are considered the most expensive form of employer sponsored retirement plan. Because of this expense, less costly alternatives have been replacing pensions at a rapid rate over the last few decades.

Social Security

Social Security is not technically a defined benefit plan since the employee makes contributions to the fund, but it shares key similarities. Social Security is a government-administered retirement system that seeks to replace a portion of income for retirees. Most people have one or more additional retirement savings plans to supplement the income received from Social Security.

Social Security was introduced during the Great Depression to ensure retirees continue to have income once they are no longer working. Most employees are automatically enrolled through payroll taxes. Benefits are generated from these worker contributions along with their corresponding employer contributions. This automatic enrollment makes Social Security a part of almost all working Americans’ retirement plans.

Who’s Eligible

Employees who’ve paid into the Social Security system for 10 or more years and are at least 62 years old are eligible to receive Social Security retirement benefits. Spouses and former spouses are also potentially eligible for Social Security benefits.

Benefits & Limitations

The Social Security benefit replaces a portion of your pre-retirement income – based on your highest 35 years of earnings. The income amount can vary, depending on how much is earned during employment and when you choose to start receiving benefits. Social Security beneficiaries generally receive approximately 40% of their pre-retirement income from Social Security.

Some individuals will pay federal income taxes on Social Security benefits. This is common if you have income in addition to your benefits, such as employment wages, self-employment income, interest, dividends, or other taxable income.

One important advantage of Social Security is the program allows you some control over when you begin receiving benefits. Those who choose to delay receiving benefits until their full retirement age – 67 for those born after 1959, or until the latest age of 70 – will receive higher monthly payments. The program also allows eligible non-working spouses to receive benefits.

On the other hand, there are some drawbacks to Social Security. For example, some people are not eligible for benefits or will have their benefits reduced because of other pension income. Additionally, funds for the program are dwindling nationally, which could result in higher taxes, lower benefits, or even cuts to the program.

Defined Contribution Plans

Defined contribution plans allow employees to invest money for their retirement and choose their own investments. These plans do not provide a guaranteed level of income in retirement. Instead, income can vary depending on the investments you choose. There are many different types of Defined Contribution Plans, some of which are sponsored by employers and others that are individually managed.

401(k)

A 401(k) is a retirement plan offered by some employers. Within the category of 401(k)s, there are several options including Traditional 401(k) plans, Roth 401(k) plans, and Solo 401(k) plans. Contributions to these accounts that you make as an employee always belong to you, but contributions and matching contributions made by your employer could be subject to a vesting schedule.

Traditional 401(k)

With a traditional 401(k) plan, employees can contribute pre-tax money through automatic payroll deduction, and employers may match all or a portion of employee contributions. Employers also have the option to make non-matching contributions to your 401(k), but this is less common.

Who’s Eligible

401(k) plans are company-sponsored, meaning that eligibility for this type of account will be based on what your employer offers.

Benefits & Limitations

A Traditional 401(k) is a pre-tax plan. Employee contributions are tax deductible in the year that they are made, and income tax is due when withdrawals are taken from the account. This means that neither the employee’s investment nor the gains are taxed as income until they are withdrawn.

The amount that can be invested each year into a traditional 401(k) is limited. For 2023, employees can contribute up to $22,500. Your employer can contribute to the account up to a combined maximum of employee and employer contributions of $66,000. Employees over the age of 50 can contribute an additional $7,500 annually.

With all plans there are some limitations and the same is true for a 401(k). You will be restricted to the investment options that your employer offers. The most common investment vehicle for 401(k)s is the mutual fund, but your employer may also make company stock, individual stocks, bonds, ETFs, and variable annuities available to you. Some 401(k) plans require maintenance or other fees, so you should be aware of those. Withdrawals while you are working are accompanied by a stiff penalty, so many who need cash will opt to borrow against their savings if loans are available within the plan – rather than making an early withdrawal.

When changing jobs, you can choose to withdraw the funds, roll them over to an IRA, or roll them over into your new employer’s 401(k). If you choose to withdraw the funds prior to retirement, you will be taxed for the full withdrawal amount. Further, if you do not meet the age requirement, you will likely pay a 10% early distribution penalty. In many cases, you can maintain the tax advantaged status and avoid penalties by rolling the contributions into another eligible retirement account. You are also required to make minimum withdrawals from the account at a certain age as required by Required Minimum Distribution [RMD] rules. Beginning January 1, 2023, the RMD age was increased to 73. It will be further increased to 75 in 2033.

Roth 401(k)

A Roth 401(k) is like a Traditional 401(k) in some ways, but unlike the Traditional variety, the Roth 401(k) is a post-tax plan. This means contributions are made after taxes are paid and investment gains can be withdrawn tax free.

Who’s Eligible

Like a Traditional 401(k), eligibility for a Roth 401(k) depends on whether your employer offers that type of plan. Some employers offer both Roth and Traditional 401(k) options. If your employer offers both, you may be able to split contributions between the Traditional and Roth options.

Benefits & Limitations

Since contributions to a Roth 401(k) are made after your income is taxed, you will not be taxed for withdrawals you make from the account in retirement. This means the money you invest, and the associated gains, can be withdrawn tax-free at retirement. There are certain requirements to ensure your withdrawals are penalty free, such as being at least 59½ years of age and the account being open for a minimum of five years. In addition, withdrawals before age 59 ½ could be subject to a 10% penalty on earnings.

Contribution limits are the same for both Traditional and Roth 401(k) plans. If you have both plans, your combined contributions are subject to those same limitations. For 2023, the limits are $66,000 total, with a maximum of $22,500 of employee contributions. Those over the age of 50 can contribute an additional $7,500 annually. Unlike Roth IRAs which will be discussed later, Roth 401(k) contributions are not subject to income limits.

If you leave your job, you can withdraw contributions made to a Roth 401(k) without any tax or penalty. However, any earnings will be taxed, and a 10% penalty could be applied if you are under the age of 59½. You can also roll over your Roth 401(k) into a Roth IRA or into a new employer’s Roth 401(k) plan.

Solo 401(k)

The Solo 401(k) is a variation of the Traditional and Roth plans, and it is also known as the one-person 401(k) plan. It is also sometimes called an i401(k) or Uni-k. The major difference is this plan is not provided by a 3rd party employer.

Who’s Eligible

The Solo 401(k) is for individuals who are self-employed or business owners with no employees.

Benefits & Limitations

Solo 401(k) plans are available as Traditional 401(k)s or Roth 401(k)s.

If your business has any employees, you would be ineligible for a Solo 401(k). However, you are allowed to hire your spouse and he or she can contribute to the plan.

In 2023, you can contribute 100% of your earned income up to $22,500 to a solo 401(k). You can also make employer contributions from your business up to 25% of your compensation. Total employer and employee contributions cannot exceed $66,000.  For those over age 50, you are allowed to contribute an additional $7,500 annually. For a traditional Solo 401(k), you are required to take RMDs beginning at age 73.

IRAs

Individual Retirement Accounts [IRAs] are plans that are managed by you and not your employer. As the policy holder, you must open and fund the account. There are several types of IRAs, including Roth IRA, Traditional IRA, SEP IRA, and Simple IRA. IRAs can typically be established with a bank, insurance company, brokerage firm, or other financial institution. Each type will have its own rules regarding eligibility, withdrawals, and taxation.

Roth IRA

Roth IRAs are a type of individual retirement account which allows you to make after-tax contributions. When the funds are withdrawn, they are tax-free as long as certain conditions are met.

Who’s Eligible

To be eligible for a Roth IRA, you must have earned income. Roth IRAs are beneficial for people who are looking for the flexibility to withdraw funds from a retirement account without paying taxes. These plans are also popular if you expect to have a higher level of income – and therefore a higher tax burden – in the future when you plan to withdraw the funds.

Benefits & Limitations

Your Roth IRA contributions will not be taxed upon withdrawal, as they were made on a post-tax basis. You also do not face any taxes on investment gains with this type of retirement plan if you wait until after age 59 ½ and at least five years from the year your account was established to withdraw any earnings.

There are no age-based restrictions on how long you can make contributions to a Roth IRA. However, there are income-based contribution restrictions. Your eligibility to contribute will begin to phase-out when your income reaches $138,000 for the individual filing status or $218,000 for married couple filing jointly. The maximum contribution amount for 2023 is $6,500, or $7,500 for those over age 50.

Traditional IRA

Traditional IRAs, unlike Roth IRAs, may allow you to deduct some or all your contributions from your income in the year you make the contributions. This type of account is best for those individuals with earned income who are looking to reduce their tax bill while saving for retirement.

Who’s Eligible

Almost anyone can contribute to a Traditional IRA, provided they have taxable income. However, these accounts are intended to benefit people with earned income who are looking to lower their tax bill. Additionally, these plans can be beneficial for those who make too much money to contribute to a Roth IRA.

Benefits & Limitations

The major draw of a Traditional IRA is the tax benefit. Contributions reduce your taxable income in the year you make them, so you can expect to pay the standard income tax rate when it is time to begin withdrawing funds from the account. Those who expect to have lower taxable income at the time they make their withdrawals can benefit greatly from these accounts. In addition, these funds will grow on a tax-deferred basis, which can provide significant benefits over time.

Individuals can contribute up to $6,500 to a Traditional IRA for 2023. For those aged 50 and older, the limit is $7,500 annually to account for catch-up contributions. The amount of your Traditional IRA contributions that can be deducted from taxable income depends on your filing status and income.

As with a Roth IRA, you can now contribute to a Traditional IRA at any age if you have earned income. Unlike a 401(k), you can withdraw funds at any time, even if you are still employed. If you withdraw funds before age 59½, you will owe tax on the distribution plus you may be required to pay a 10% penalty.  At age 73, you will be required to take out a portion of the account as an RMD.

SEP IRA

A Simplified Employment Pension [SEP] is an IRA retirement plan that is intended for small business owners and those who are self-employed. These plans do not have the start-up and operating costs of a conventional employer sponsored retirement plan.

Who’s Eligible

Individuals who are self-employed or small business owners are eligible to establish a SEP IRA. Business owners who open a SEP IRA are required to establish accounts for eligible employees if they have any.

Benefits & Limitations

Contributions to a SEP IRA are made by an employer and are tax deductible by the business. Employees cannot make contributions to a SEP IRA, but they can contribute to a Traditional or Roth IRA as an individual, even if they also participate in a SEP IRA.

The contribution limit for a SEP IRA is higher than with the Traditional or Roth IRA options. The limitations in 2023 are either $66,000 or 25% of your earned income, whichever is less. If you are self-employed, the limit is reduced to 20% of your net income. SEP IRAs are easy to set up and maintain and often have lower costs than other retirement plan options. Employees can invest in mutual funds, stocks, bonds, annuities, and other investment options.

Withdrawals are allowed for any reason, even if you are still employed. However, they are subject to tax and may be subject to an additional 10% penalty if you are under age 59 ½. During retirement, withdrawals are taxed as income and subject to RMDs at age 73. Loans are not an option with a SEP IRA. Finally, SEP IRA contributions are immediately 100% vested.

SIMPLE IRA

The Savings Incentive Match Plan for Employees, also known as the SIMPLE IRA, is a plan that is established by the employer. The employer is required to contribute to the accounts of participating employees.

Who’s Eligible

SIMPLE IRAs are intended for small businesses and self-employed people. Employers with fewer than 100 employees are allowed to establish these retirement plans.

Benefits & Limitations

Unlike SEP IRAs, employees are eligible to make contributions to a SIMPLE IRA account.  Employee contributions are made on a pre-tax basis. In addition, funds that you invest will grow tax-deferred – meaning they are taxed when you take a distribution from the account.

SIMPLE IRA accounts are immediately 100% vested and the owner of the account can take a distribution at any time. However, if you take a distribution before age 59 ½, you may face a penalty of up to 25%. The penalty is reduced to 10% if your account has been active for two years prior to the distribution.

Employers who establish SIMPLE IRAs for their employees must contribute to their eligible employee’s accounts. The employer can choose to contribute a flat rate of 2% for all employees – regardless of whether the employee also contributes to the account. More commonly, employers can match 100% of employees’ contributions up to 3% of their compensation.

As with most retirement plans, there are contribution limits and guidelines. The employee contribution limit for 2023 is $15,500, with those ages 50 and older being eligible to make catch up contributions of $3,500. Employer contributions are not included in the $15,500 limit.

403(b)

A 403(b) plan is similar to a 401(k) plan but is intended for employees of tax-exempt organizations. A 403(b) is also called a tax-sheltered annuity [TSA] plan. Employees with these plans can save for retirement through contributions to their individual accounts and through employer matching if offered.

Who’s Eligible

Employees of tax-exempt organizations like public schools, non-profit agencies, and churches can be eligible for 403(b) plans if their employer sponsors the plan.

Benefits & Limitations

Employers might offer 403(b) plans as part of a benefits package and may match your contributions as an employee. You will have a choice of investments when you defer earnings to a 403(b) plan. Your employer will choose which investments are available for you, and the options can include annuities, mutual funds, or a retirement income account. One major limitation to these plans is individual stocks, bonds, and ETFs are not available as investments.

In a Traditional 403(b) plan, contributions are made on a pre-tax basis. Neither these contributions nor their earnings are taxed until the funds are withdrawn during retirement. In a Roth 403(b) plan, contributions are made with after tax money and distributions are not taxed when taken after age 59 ½.

For 2023, the contribution limits for a 403(b) are $66,000 total, with a maximum of $22,500 of employee contributions. Those over the age of 50 or with over 15 years of service may qualify to make additional “catch-up” contributions over the normal limits.

Any contributions that you made as an employee to a 403(b) can be taken with you if you change jobs. If you are vested prior to your job change, you will maintain all your employer-made contributions. However, if you are not fully vested, you may lose all or some of the contributions made by your employer.

Funds withdrawn from a 403(b) prior to the age of 59½ may be subject to a 10% tax penalty. Early withdrawals are generally not allowed but account holders can usually take out loans against the plan if they need emergency cash. At age 73, you will be required to take out a portion of the account as an RMD.

457(b)

A 457(b) plan is a deferred compensation plan offered through government or other special types of employers. Contributions are taken from your paycheck on a pre-tax basis, lowering your taxable income, and remain untaxed until the funds are withdrawn. Some plans offer a Roth option – where contributions can be made after taxes are paid. In this case, funds would be withdrawn tax-free when qualifying conditions are met.

Who’s Eligible

Those eligible for 457(b) plans typically include state and local government employees, such as police officers, firefighters, and government officers. Public school teachers are also commonly eligible for this type of plan. There are some employees at nonprofit agencies such as hospitals, charities, and unions who are also able to use 457(b) plans.

Benefits & Limitations

457(b) plans generally offer two types of investments: annuities or mutual funds. These types of investments are not taxed until funds are withdrawn in retirement. 457(b) plans work well with other plans, such as 403(b), making them a desirable retirement plan option for some.

The contribution limit for 457(b) plans in 2023 is $22,500, which includes employee deferrals and any contributions made by the employer. Those aged 50 and older may be eligible to make catch-up contributions in three years before reaching retirement age. This additional amount can allow you to contribute up to twice the maximum annual contribution. Eligibility will be based on the details of your plan.

With 457(b) plans, there is no tax penalty for early withdrawals if the withdrawal is for a qualifying hardship or you have separated from your participating employer. A downside to 457(b) plans is that not everyone will qualify since the plans target a specific audience for eligibility. Also, these plans do not have the same type of employer match as found with a 403(b). In addition, be careful because some 457 plans do not allow rollovers into an IRA if you change jobs.

HSA

There are some other types of accounts and plans that aren’t designed specifically for retirement but can allow certain individuals added benefits when saving for retirement. One of the lesser known, but most important is the Health Savings Account [HSA].

Health Savings Accounts [HSAs] are similar to personal savings or investing accounts, but they can only be used for qualified healthcare expenses during your working years, as identified in your plan. HSAs allow you to set aside pre-tax funds to be used for those qualified expenses. These funds can grow in the account, tax-free, until they are used for a qualified expense. However, what many people don’t realize is that funds that remain in an HSA after retirement can be withdrawn without penalty for any purpose.

Who’s Eligible

To be eligible for an HSA, you must be enrolled in a qualifying High-Deductible Health Plan [HDHP] during the years you make contributions. Qualifying health plans will typically identify themselves as HSA-eligible.

Benefits & Limitations

Funds for HSA are deposited before taxes and may lower your taxable income. As you pay for qualified medical expenses, withdrawals from the HSA are not taxed. Funds in the account can be invested in mutual funds, stocks, ETFs, and other investment vehicles defined by the HSA provider. Unused funds at the end of the year roll over to the next year.

A drawback to the HSA is the required HDHP. The 2023 minimum deductible for a qualifying health plan is $1,500 for individuals and $3,000 for families. These plans are not suited for every situation, particularly if you expect to have significant healthcare expenses.

If you have an eligible HDHP, you can contribute up to $3,850 to an HSA in 2023 as an individual, and families can save up to $7,750. Individuals aged 55 and over can contribute an additional $1,000 per year as a catch-up contribution. Those who have any form of Medicare are ineligible to contribute to an HSA. Withdrawals are tax-free within the allowable parameters, but if you withdraw funds prior to age 65 that are not for qualified expenses, you will owe income tax on the withdrawn amount, plus a penalty of 20%.

HSAs can be set up through your employer or individually. If you set up your HSA through your employer and then leave the company, you keep the money that you have invested. In some cases, HSAs may charge a monthly fee, but this is specific to each institution.

Understand Your Retirement Account Options

As you can see there are a huge number of different options for your retirement savings. After reading this article, you understand the basics, but it is wise to consult an experienced financial advisor anytime you plan to change jobs and, most importantly, before choosing an account to grow your retirement nest egg!

Get Your Financial Fingerprint™ at Meld Financial

As you navigate the process of planning your retirement, you can gain confidence in your future by having a team of professionals at your side. The team at Meld Financial can leverage our vast experience – almost 4 decades serving your neighbors – to help you choose the retirement savings plan that matches your situation. Our  team of financial and legal professionals can also help you develop your Financial Fingerprint™.

Financial Fingerprint™ is a unique financial planning process developed at Meld through several decades of managing our clients’ wealth. In short, your Financial Fingerprint™ is a plan that is quick to assembleeasy to understand and simple to modify as your circumstances change. This plan covers the most important aspects of your retirement including saving, investing, and maximizing benefits from your retirement accounts.

If you’re ready to talk, contact us today to schedule a short meeting with a member of our team.

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