Deciding upon the best retirement account can be a daunting prospect, given the sheer number of retirement plans that are available to investors. Which retirement vehicle you choose will be dependent on numerous components – whether you are self-employed, have a private employer, or are a small business owner. Each retirement account has its advantages and drawbacks. Ultimately, your choice of retirement account will depend upon your retirement goals.
Below is a list brief synopsis of each retirement account available:
A self-directed IRA (or SDIRA) is a type of retirement account that permits a myriad of diversified assets not allowed in other IRAs. In addition, a self-directed IRA is solely managed by you the investor. Although under federal law, you must have a custodian who acts as an administrator over this type of retirement vehicle.
Essentially, the IRS has imposed little restrictions on what you can hold in a self-directed IRA. Unlike other IRAs, this type of retirement vehicle can be used to invest in everything from precious metals and real estate, to commodities. Akin to other IRAs, the only investments not allowed in a self-directed IRA are S corporation stock, collectibles, and insurance investments.
Under IRS rules, self-directed IRAs are subject to the same contribution limits and distribution (withdrawal) limits as traditional and Roth IRAs. For 2020, total contributions to a self-directed IRA $6,000. For individuals 50 years old and older, the limit is $7,000. Likewise, with other types of retirement accounts, self-directed IRAs have a 10% early-withdrawal penalty on the funds,
Any individual retirement account should be regarded as a long-term investment. Yet, a self-directed IRA provides far greater potential for growth given the types of assets that can be held inside this retirement vehicle.
In 1974, Traditional Individual Retirement Accounts (IRAs) were first introduced through the Employee Retirement Income Security Act (ERISA). An IRA is an investment vehicle specifically designed to accumulate funds for retirement. The savings within an IRA are not subject to taxation until withdrawn from the retirement account.
Two simple criteria must be met for opening a traditional IRA: being under 70 ½ years old, and earning taxable income. As of 2020, the IRS rules for annual contribution limits to a traditional IRA is $6,000 ($7,000 for those 50 years old or older), or cannot exceed “your taxable compensation for the year, if your compensation was less than this dollar limit”.
For 2020 and beyond, there is no longer any age limit to making contributions to either a traditional IRA, or a Roth IRA. Similar to other types of retirement accounts, traditional IRAs have a 10% early-withdrawal penalty on the funds if you make distributions prior to 59 ½, with the IRS making some exceptions in extenuating circumstances. Required minimum distributions (RMDs) are applicable to traditional IRAs. New IRS regulations regarding withdrawals based upon the Setting Every Community Up for Retirement Enhancement (SECURE) Act outline that if an individual turned 70 years old on July 1, 2019, or later, then withdrawals from a traditional IRA are not mandatory until the individual turns 72.
A traditional IRA offers numerous investment options, however, the IRA custodian may put limitations on the sort of assets that are available. It is important to note that the IRS does not permit funds from a traditional IRA to be invested in physical assets such as precious metals bullion or real estate.
A 401(k) is categorized as a “defined contribution plan”, where the employee funds the account with paycheck deductions prior to taxation. Additionally, with some 401(k) plans, the employer will make proportionally matched contributions to the account based on elective deferrals of the employees.
This type of qualified plan was first introduced in 1980 by attorney and benefits consultant, Ted Benna. In 1978, the section of the Internal Revenue Code, 401(k) became enacted legislation. The impetus for this legislation had been to permit a tax break on deferred income. Benna realized that the 401(k) provision could be utilized as a straightforward, tax-advantaged method for employees to save for retirement. In the US, 401(k) plans are now the most popular type of retirement plan, and are offered by virtually every employer.
The main advantage of 401(k) plans is the potential for contributions to be proportionally matched by the employer, which are not taxed and allow the participant to exceed the contribution limits outlined by the Internal Revenue Agency (IRS). However, this type of retirement vehicle is limited by the investment options permitted within the account. As per the IRS regulations, funds from a 401(k) cannot be used to invest in numerous alternative assets, such as precious metals and real estate.
A Roth IRA is an individual retirement account, which is funded with after-tax dollars and permits tax-free withdrawals. First introduced through the Taxpayer Relief Act of 1997, this retirement account gets its name from Senator William Roth. Akin to traditional IRAs in many respects, Roth IRAs are available to employees independent of their place of employment. However, the Internal Revenue Agency (IRS) has made some strict distinctions with a Roth IRA, especially pertaining to tax regulations. As per the IRS rules, you are not permitted to deduct contributions to Roth IRAs on a tax return. However, a major advantage is that the IRS will not tax Roth IRA distributions upon retirement if you meet certain criteria.
Another advantage with this type of retirement account is that contributions can be made to a Roth IRA after 70 ½. Additionally, regulations have changed regarding withdrawals based upon the Setting Every Community Up for Retirement Enhancement (SECURE) Act. It is important to note that the IRS does not require withdrawals from a Roth IRA until the account owner has died.
For 2020, total contributions for both Roth IRAs and traditional IRAs is $6,000. For individuals 50 years old and older, the limit is $7,000. Likewise, with other types of retirement accounts, Roth IRAs have a 10% early-withdrawal penalty on the funds, and 6% annual penalty tax on excess contributions to the account.
A Roth IRA offers numerous investment options, however, the IRA custodian may limit the sort of assets that you can choose from. It is important to note that the IRS does not permit funds from a Roth IRA to be invested in physical assets such as precious metals bullion or real estate.
A 457(b) plan (also deemed by the IRS as a 457(b) Deferred Compensation Plan) is a tax-advantaged, employer-sponsored, deferred-compensation plan that can be offered by state or local government organizations, or nonprofit employers. The term refers to section 457 of the Internal Revenue Code.
First introduced in 1978, these retirement vehicles are categorized as “defined contribution plans”, and are akin to 401(k) plans. The primary difference is that this plan was specifically designed for two types of employers – government employers and some NGOs (non-governmental organizations). Eligible participants to a 457(b) plan make paycheck deductions prior to taxation to the account. Annual contributions cannot exceed up to 100% of the participant’s includable income, or $19,500 for 2020. Contributions within this type of retirement account remain tax-free until a withdrawal is made.
Essentially, there are two variations of this sort of retirement plan: governmental and a non-governmental 457(b) which is for upper-level management and executives and as per the IRS regulations “cannot cover rank-and-file employees”.
Typically, private companies offer non-governmental 457(b) plans, thus restricting participation only to upper-level management and executives. It is important to note that investment options available with this retirement vehicle are limited to what is offered by the plan provider.
The Internal Revenue Service (IRS) defines an annuity as “a contract that requires regular payments for more than one full year to the person entitled to receive the payments (annuitant). You can buy an annuity contract alone or with the help of your employer”. These investment vehicles are an insurance product that has become a popular means of saving for retirement because they are tax-advantaged. Akin to an IRA, earnings within an annuity provide tax-free growth until the funds are withdrawn. Many investors opt for annuities because they provide the peace of mind of a steady income stream during retirement years.
Annuities come in two different types, based on how the investment vehicle is funded – an immediate annuity, or a deferred annuity. Immediate annuities are where the insurance product is funded in one lump-sum. In return, the investor begins receiving immediate tax-deferred income. Conversely, with a deferred annuity, structured periodic payments are made to the investment vehicle. During one’s retirement years, the accumulated funds provide a guaranteed income stream.
A Simplified Employee Pension (SEP, or SEP IRA) enables employers to make contributions to retirement accounts for both themselves and employees as outlined by the Internal Revenue Service (IRS). This type of retirement account is an alternate form of a traditional IRA. As per the IRS requirements, “all contributions must go to a traditional IRA, and employees are responsible for making investment decisions about their SEP-IRA accounts”. Only the employer makes contributions to these retirement accounts, and employees are completely vested in all funds within their respective SEP IRA.
Every eligible employee has an individual SEP IRA set-up for them. The IRS defines an “eligible employee” as an individual who has made at least $600 from the employer during the calendar year, is at least age 21, and been employed by the employer “at least 3 of the last 5 years”.
Because SEP IRAs are an alternate form of traditional IRAs, these retirement vehicles have identical investment options. In addition, the same rules for Required Minimum Distributions (RMDs) are applicable. Based upon the Setting Every Community Up for Retirement Enhancement (SECURE) Act, if an individual turned 70 years old on July 1, 2019, or later, then withdrawals from a SEP IRA are not mandatory until the individual turns 72.
A SIMPLE (Savings Incentive Match Plan for Employees) IRA provides small businesses with 100 or fewer employees, the ability to offer retirement plans. Both the employer and employees can make contributions to this type of retirement account, and employees are completely vested in all funds within their SIMPLE IRA. An advantage of SIMPLE IRAs is they are not subject to the restrictions and guidelines of the Employee Retirement Income Security Act (ERISA).
As per the Internal Revenue Sevice (IRS) regulations, total contributions are limited for this type of retirement vehicle. In fact, a disadvantage of SIMPLE IRAs is their lower contribution limits compared to other available retirement accounts (for 2020, the limit is $13,500). Total contributions include salary reduction contributions, and employer contributions which can be either nonelective contributions or matching contributions.
In addition, the IRS has placed stringent restrictions on a SIMPLE IRA rollover compared to other retirement vehicles. There is a two-year waiting period after initial participation in the plan commenced.
A Solo 401(k) plan is also referred to as the “One-Participant 401(k) Plan”. The Internal Revenue Agency (IRS) stipulates that both a standard 401(k) plan and a Solo 401(k) are subject to the identical requirements and regulations. The only difference is a Solo 401(k) permits a business owner (and his or her spouse) to participate in a qualified defined contribution plan.
This tax-advantaged retirement savings plan was first introduced in the Economic Growth and Tax Relief Reconciliation Act of 2001. The impetus for their introduction was to provide self-employed individuals (and their spouses) the opportunity to participate in employer-sponsored retirement plans.
As per the IRS rules, a Solo 401(k) plan is governed by the same regulations as standard 401(k) plans – the only difference being that no additional employees can be hired by the small business to be eligible for this type of retirement vehicle. Additionally, unlike a 401(k), Solo 401(k) plans are not subject to the restrictions of the Employee Retirement Income Security Act (ERISA).
Contributions to a Solo 401(k) plan are made as both employer and employee. For 2020, the “employee” contribution limit is $19,500 and $26,000 for those 50 years old and older. The total contributions to this type of retirement account cannot exceed $57,000 ($63,500 if 50 or older), not including catch-up contributions for those 50 years old and older.
A benefit of a Solo 401(k) plan is that unlike an IRA, you are not required by law to use a custodian. Under IRS regulations, you are permitted to hold certain types of precious metal coins and bullion in the physical possession of a US financial institution, which functions as a trustee.
A Thrift Savings Plan (TSP) is a type of retirement vehicle designed specifically for federal employees and members of the uniformed services. This defined contribution plan was first introduced through the Federal Employees’ Retirement System Act of 1986 (FERS), and is similar to a 401(k).
The Thrift Savings Plan is one of three components of the Federal Employees’ Retirement System, which includes Social Security and FERS annuities. As with other defined-contribution plans, the employee funds the account with paycheck deductions prior to taxation. Additionally, with some TSPs, the federal government will make proportionally matched contributions to the account based on elective deferrals of the employees.
Contributions to a TSP are kept in the Thrift Savings Fund, and is administered by the five-member, presidentially appointed, Federal Retirement Thrift Investment Board. The Thrift Savings Fund is comprised of numerous different investment funds which are mutual fund portfolios, including the Government Securities Investment (G) Fund, the Lifecycle (L) Fund, in addition to the C, F, I, and S Funds which are index funds. As per Internal Revenue Service restrictions, individual securities are not permitted with a Thrift Savings Plan.
An Employee Stock Ownership Plan (commonly known as ESOP, for short) is categorized as a qualified defined contribution plan and allows employers to provide company stocks to employees. The Internal Revenue Agency (IRS) defines ESOPs as “an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan. An ESOP must be designed to invest primarily in qualifying employer securities as defined by IRC section 4975(e)(8) and meet certain requirements of the Code and regulations. The IRS and Department of Labor share jurisdiction over some ESOP features”.
Companies who choose to opt for an ESOP, establish a trust fund, and contribute stock or cash to purchase existing company stock. These employee benefit plans are the most popular way for employees to gain an ownership interest in their respective workplaces.
Stock allocation to an ESOP trust fund varies between companies, however, all employer contributions go directly into individual accounts of employees. These employer contributions are tax-deductible, and likewise, employees are not taxed on the contributions.
Employees are not fully vested in their respective shares until achieving seniority within the company – the IRS stipulates that workers must be fully vested within 3 to 6 years. Once an employee departs the company, the employer must purchase back the respective allocated company stock.
A Keogh Plan is categorized as a “qualified plan” by the Internal Revenue Service (IRS), and designed for a self-employed individual who runs a small business and their employees. Unincorporated businesses that are classified as sole proprietors or partnerships are eligible to set-up this type of retirement plan. However, as per IRS rules, “a common-law employee or a partner can’t set up one of these plans”.
This type of tax-advantaged retirement vehicle was first introduced in 1962 by Congressman Eugene Keogh, through the Self-Employed Individuals Tax Retirement Act. However, the structure of the plan was altered in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. The IRS explains that “retirement plans for self-employed people were formerly referred to as ‘Keogh plans’ after the law that first allowed unincorporated businesses to sponsor retirement plans. Since the law no longer distinguishes between corporate and other plan sponsors, the term is seldom used.”
Keogh Plans are now commonly referred to as “H.R. 10 plans” and are categorized as qualified plans. There are two types of qualified plans: defined contribution and defined benefit. A defined contribution Keogh is established in the same manner as either a money purchase pension plan, or a profit-sharing plan. Conversely, a qualified plan categorized as a defined benefit Keogh, is structured like a regular pension plan. The IRS rules stipulate that “contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants.”
It is important to note that a Keogh Plan necessitates a considerable amount of paperwork each year, as stipulated by the IRS. Specifically, Form 5500 must be filed on an annual basis.
A Money Purchase Plan is categorized as a “defined contribution plan”, where annual contributions made by the employer are a predetermined percentage of each eligible employee’s salary. The salary percentage for each participant does not fluctuate, as outlined in the details of the specific plan.
This type of retirement vehicle is deemed a “qualified plan”, therefore funds within the account are tax-deferred until a distribution is made. Likewise, contributions to Money Purchase Plans are tax-deductible. Although eligible employees do not make contributions, they do decide how the funds are invested, based on the investment limitations specified by the plan.
A major advantage of a Money Purchase Plan is that it can be a valuable addition to retirement savings. Under the guidelines outlined by the Internal Revenue Service (IRS), an employee is permitted to have additional savings plans such as a 401(k). A drawback is the higher administrative costs associated with these retirement vehicles.
A Profit-Sharing Plan is a type of retirement account where contributions are determined by the profitability of a company. Employers decide when to make contributions to participating employee accounts dependent upon either quarterly or annual earnings of the company. The Internal Revenue Service (IRS) refers to this as “discretionary employer contributions”. As outlined by the IRS, the most popular way to allocate each employee’s contribution percentage for a Profit-Sharing Plan is via the “comp-to-comp” method”. As per the IRS guidelines, “the employer calculates the sum of all of its employees’ compensation (the total “comp”). To determine each employee’s allocation of the employer’s contribution, you divide the employee’s compensation (employee “comp”) by the total comp. You then multiply each employee’s fraction by the amount of the employer contribution. Using this method will get you each employee’s share of the employer contribution”.
Profit-Sharing Plans are categorized as “qualified plans”, therefore funds within the account are tax-deferred until a distribution is made. A major advantage of a Profit-Sharing Plan is that it can be a valuable addition to retirement savings. Under the guidelines outlined by the (IRS), employers are permitted to establish a Profit-Sharing Plan even if they have additional retirement plans such as a 401(k). A drawback is the higher administrative costs associated with these retirement vehicles.
A Salary Reduction Simplified Employee Pension Plan (or SARSEP as it was referred to as) is a retirement vehicle that was available to small businesses with only 25 employees or less. After January 1, 1997, SARSEPs were superseded by SIMPLE IRAs, as a component of the Small Business Job Protection Act of 1996. However, a SARSEP established prior to 1997 can still be used. As per the Internal Revenue Service guidelines pertaining to these retirement accounts, “employers who established SARSEPs prior to January 1, 1997, can continue to maintain them and new employees of the employers hired after December 31, 1996, can participate in the existing SARSEPs”, as long as they have been employed by the company for three of the last five years.
With a SARSEP, it is mandatory that all contributions be kept in an individual SEP-IRA established for each participating employee. Contributions for this type of retirement account are both employee salary reduction contributions and nonelective employer contributions.
For 2020, the salary reduction contributions of SARSEP participants cannot exceed $19,500, or be more than 25% of a total annual income. Total contributions of both employee and employer are the same as a SEP IRA, $57,000 for 2020. The IRS permits catch-up contributions with this type of retirement vehicle.
A SARSEP has the same distribution limitations as other types of retirement accounts. SARSEPS have a 10% early-withdrawal penalty on the funds if you make distributions prior to 59 ½, with the IRS making some exceptions in extenuating circumstances.
You can also learn more about the various types of retirement plans via the IRS here.