What are The Different Types of Retirement Accounts: 401(k), IRA, Roth IRA, SEP

Everyone should save for retirement, but many people are unsure which plan would be best for them. To help you decide, we’ve looked at the four most popular retirement plans to see how they stack up against one another. 401(k)s, Traditional IRAs, Roth IRAs, and SEPs: which one(s) are right for you?

401(k)

• ELIGIBILITY: Employees
• SPONSOR: Employer
• TAXES ON CONTRIBUTIONS: No
• TAXES ON DISBURSEMENTS: Yes
• CONTRIBUTION LIMIT: $23,500 (+$7,500 for 50-yo and older)
• REQUIRED MINIMUM DISTRIBUTIONS: Yes (can be deferred until retirement)

A 401(k) is a company-sponsored retirement plan where employees designate a set percentage of their gross income for automatic deposit into their account. Employers may (but are not required) offer matching contributions to a 401(k). The most common form of employer matching is 50 cents for every dollar an employee contributes, up to 6% of their salary.

Combined employee contributions plus employer contribution matching for a 401(k) is limited to $69,000 or 100% of employee salary annually, plus $7,500 in “catch up” contributions for employees age 50 or older. Employees should always contribute at least up to the limit to employer matching. Not doing so leaves free money on the table.

401(k)s act like a traditional IRA. Contributions are made from pre-tax income, reducing an investor’s taxable income, but disbursements are taxed. Roth 401(k)s were first offered in 2006. These follow the same characteristics as a normal Roth IRA: Contributions are made from after-tax income, but disbursements are not taxed. In either case, required minimum disbursements (RMD) can be delayed until after retirement.

Traditional IRA

• ELIGIBILITY: Individual
• SPONSOR: Individual
• TAXES ON CONTRIBUTIONS: No
• TAXES ON DISBURSEMENTS: Yes
• CONTRIBUTION LIMIT: $7,000 (+$1,000 if over 50 yo)
• REQUIRED MINIMUM DISTRIBUTIONS: Yes

An IRA is a tax-advantaged individual retirement plan not tied to an employer. IRAs were created in response to the changing economy, as fewer companies offered pension plans and workers were more likely to be laid off or change jobs.

IRAs were introduced in 1974 for employees working at a company that did not offer a pension. Eligibility was broadened in 1981 to include all workers and their spouses. Compared to a 401 (k), IRAs have a wider selection of eligible investments. Most stocks, bonds, ETFs, and mutual funds can be included in an IRA.

Contributions to traditional IRAs are tax-deductible*, and their investments are allowed to grow tax-free. Disbursements are taxed as regular income using the owner’s tax bracket at the time.

Any withdrawals before then are considered early distributions, subject to Federal and state income tax and possibly an additional 10% penalty paid to the IRS. There are certain partial exemptions from the 10% penalty for early distributions, such as medical expenses and buying a first home. Check with your tax advisor to see if you qualify.

IRAs have much smaller annual contribution limits than 401(k)s. IRA contributions are capped at $7,000 (+1,000 for “catch-up” contributions if age 50 or over). While investors can have multiple IRAs (both traditional and Roth), they share the same single $7,000 contribution limit. Unlike Roth IRAs, there is no income limit to contributing to a traditional IRA.

*The amount of contributions that are tax-deductible depends on your Modified Adjust Gross Income.

Roth IRA

• ELIGIBILITY: Individual
• SPONSOR: Individual
• TAXES ON CONTRIBUTIONS: Yes
• TAXES ON DISBURSEMENTS: No
• CONTRIBUTION LIMIT: $7,000 (+$1,000 if over 50 yo)
• REQUIRED MINIMUM DISTRIBUTIONS: Not until the death of the owner

Roth IRAs were introduced in 1997. The tax implications of contributions and withdrawals for a Roth IRA are the opposite of those of traditional IRAs. Contributions are made with after-tax dollars, but disbursements are tax-free. This makes Roth IRAs appealing to investors who expect to be in a higher tax bracket upon retirement.

Due to this structure, Roth IRAs have limits on who can participate*. This was done to prevent high net-worth individuals from taking undue advantage of the tax-free disbursements they offer.

However, since you have already paid taxes on the money you contribute to a Roth IRA, you can withdraw it without penalty. This only applies to the money you contributed, not the earnings of the assets in your account. Earnings are subject to the same restrictions that a traditional IRA has - Withdrawal of earnings (not contributions) before the age of 59-½ may incur a 10% early withdrawal penalty.

Another way that Roth IRAs differ from traditional IRAs is that they have no Required Minimum Distributions. In fact, there are no requirements to take any distributions at all for the life of the owner. Roth IRAs also allow you to continue making contributions after the age of 72.

*See IRS publication 590-A to calculate your eligibility to participate in a Roth IRA.

SEP

• ELIGIBILITY: Employees
• SPONSOR: Employer
• TAXES ON CONTRIBUTIONS: No
• TAXES ON DISBURSEMENTS: Yes
• CONTRIBUTION LIMIT: 25% of Employee salary or $69,000
• REQUIRED MINIMUM DISTRIBUTIONS: Same as Traditional IRAs

Simplified Employee Pension plans (SEP) were developed to give small business owners a simplified way to provide a retirement plan for themselves and their employees. SEPs do not have the start-up and operating costs of a conventional 401(k).

Under a SEP, employers set up individual traditional IRAs for each employee. Only the employer can contribute to SEP IRAs. The plan allows employers the flexibility to pause contributions when business is slow, which is a boon to small companies in cyclical business. Company contributions to SEP IRAs are tax-deductible.

SEPs have much higher contribution limits compared to regular IRAs. Companies can contribute up to 25% of an employee’s compensation or $69,000, whichever is less. Percentage-based contributions are based on each employee’s compensation, which means that employees with higher pay will see a larger dollar contribution than a lower-paid employee, though the percentage of contributions is the same.

Employees are each 100% vested in their SEP IRA, even though the employer makes the contributions. Employees who leave the company are entitled to roll over their SEP IRA into a traditional IRA or a 401(k) or 404(d) offered by their new employer. Rolling the SEP IRA into a Roth IRA comes with tax implications.