There is a large and growing list of investing accounts, particularly retirement plan options — how do you know which is right for you? Sometimes it’s just a matter of comparing the pros and cons of the various investing accounts, then deciding which holds the most advantages to you based on what each offers.
Let’s look at the most popular accounts available, and see how they compare to each other.
Each section is broken down into the type of retirement account, and includes:
- Traditional 401(k) Plans
- Solo 401(k) Plans
- Pension Plans
- SEP IRA Plans
- Traditional IRAs
- Roth IRAs
- My Retirement Accounts (MyRA)
- SIMPLE IRAs
- Permanent Life Insurance
Employer-sponsored retirement plans are generally grouped into two categories: defined benefit plans (DB) and defined contribution plans (DC).
When you’re talking about a DB plan, the employer promises to pay a specified amount to retirees who meet the eligibility criteria. In other words, the plan defines the benefit to be received, which are usually linked to the amount of service and based on final average salary. Until recently, DB plans were the dominant form of employer-sponsored retirement programs.
With DC plans, a certain amount or percentage of money is set aside each year by the company for the benefit of the employee (such as a Pension Plan — more on this below).
Here are the four most popular types of employer-sponsored 401(k) DB and DC plans.
Traditional 401(k) Plans
Many companies offer 401(k) plans allowing both the employer and the employee to benefit from building a nest egg and receiving tax breaks. Employees will be able to take advantage of an employer-match when saving money into their 401(k), while the company receives tax breaks and increases employee moral.
But not all 401(k) plans are the same. If your employer offers one of them, participating in it can certainly work in your favor. Speak with your HR department when participating in this kind of employer-sponsored retirement plan.
- High Contribution Matches – Compared to IRAs, 401(k) plans have high contribution amounts of up to $18,000 (in 2016). Many also have a partial company contribution match. So let’s say your employer will match 50% up to your contribution of 6% of your salary. If you earned $100,000, and you make contributions of at least 6% ($6,000), your employer will match it with a contribution of $3,000 (50%).
- Borrow Funds – Traditional 401(k) plans can also be borrowed against under very favorable terms, typically up to 50% of the plan value.
- Protected from Creditors – Another advantage most people don’t know about, is that 401(k) plans are generally protected from creditors.
- Yearly Tax Break – When contributing to an employer-sponsored plan you could also receive a tax credit on your personal taxes. Since the funds you contribute to the 401(k) plan are not taxed, you could qualify for a fairly large credit, as well as few other tax-saving deductions.
- Limited Investment Options – First among the cons is that they offer limited investment options. A typical employer-sponsored 401(k) may offer only a half dozen investment options, including the purchase of company stock. If you don’t like the options offered, you will have no ability to invest the money elsewhere.
- High Management Fees – 401(k) plans also typically have high fees, since the cost to maintain the plan is relatively high.
Solo 401(k) Plans
Solo 401(k) plans are basically 401(k) plans for people who are self-employed, and are similar to a regular 401(k) you would have participated in at your day job. However, if you have since left your day job, and can no longer contribute to an employer-sponsored 401(k), you can now look at the Solo 401(k) as the next best option.
Solo 401(k) plans are a bit complex to setup, since you’re required to create a document stating the rules and regulations for your company’s 401(k). Many third-party companies will require a nominal fee (usually under $1,000) to set up a Solo 401(k) plan.
- Self-Directed Account – Much like IRA accounts, Solo 401(k) plans are completely self-directed. You will have far more investment options than you will in an employer-sponsored plan.
- Control Over the Trustee – You’re allowed to make the decision as to who the plan trustee will be, and can change the trustee at any time in the future if needed.
- High Contribution Limit – One of the truly big advantages of this plan is it offers the highest possible contribution of up to $53,000.
- More Hands-On – Solo 401(k) plans are self-directed, and not everyone likes this feature. You may have to turn the plan over to a professional investment manager, if creating and managing your own investment portfolio isn’t for you.
- Must Be Self-Employed – In order to participate in this plan you must be self-employed and earn a living through your own business or other ventures.
Generally thought of as your parents’ or grandparents’ retirement plan, a pension plan was a virtual staple way back when but are harder to find as time goes on. Essentially, you worked for the same company for 30 years and at retirement, you got a gold watch and a pension plan.
All but the largest employers have abandoned these plans largely because they’re a retirement account that’s fully funded by the employer. The only benefit to the employer who participates in a pension plan now is if you’re the owner of the business and open a pension plan for yourself as an individual.
- Defined Plans with Specific Benefits – The core strength of pension plans is that they are defined benefit plans, rather than defined contribution plans, which is what most other tax-sheltered retirement plans are. Your benefits from the plan are pre-determined, based on a combination of your income and the number of years you are employed by your company.
- Employer-Maintained Account – You don’t need to make contributions, your employer handles all of this. Your employer also manages the account for you, so you will have virtually zero responsibility.
- Zero Control – The lack of responsibility for your pension plan also means you have zero control over it.
- Required Participation for Years – Pension plans typically have vesting requirements, which means you will have to participate in the plan for a minimum number of years (generally five years) before the money will become yours. The number of years you’re with an employer is a major factor in determining your benefit, so you’ll need to be in a plan for 20 years or more in order to get a decent pension plan.
SEP IRA Plans
If you’re a small business owner, the most logical option is to open a SEP (Simplified Employee Pension) IRA. Its simple setup and ease of use through many brokerage firms, makes it an attractive vehicle for saving for retirement.
Even a few robo-advisors, like Betterment, are now able to manage a SEP IRA through their service — potentially saving you hundreds of dollars in management fees.
- Contribute 25% of Your Salary – Even though it’s called a SEP IRA, you can contribute up to $53,000 or 25% of your annual salary (in 2016), or whichever is lesser.
- No Income Limits – Unlike Traditional and Roth IRAs (which are discussed in-depth below), SEP IRAs have no income limits. This means your business’ earnings won’t be capped at a certain amount of money in order to qualify.
- Flexible Contributions – If you have a tough year financially, you can choose to skip contributes this year. Then if you have a great year, you can fund the plan with a larger amount than originally intended.
- Low Annual Fees – Depending on where you open the SEP IRA account you could pay no or low annual fees.
- No Employee Contributions – A SEP IRA is best if you’re a one-person show and plan to continue that way, so employee contributions aren’t allowed. The employer is responsible for distributing funds at his discretion.
- Inclusive Participation – An employer can not selectively decide which employees will benefit from a SEP IRA. The company must contribute for the benefit of everyone, or no one.
Tax-Advantage Individual Retirement Accounts
Individual retirement accounts are likely the investment accounts most people are familiar with, and include both a Traditional IRA and a Roth IRA. Both of these have tax advantages and can be used in conjunction with a 401(k) plan (if your income qualifies).
With a Traditional IRA, you make contributions with money you may be able to deduct on your tax return. Any earnings potentially grow tax-deferred until you withdraw them in retirement.
The great thing about a Traditional IRA is that you can generally have a one even if you have an employer-sponsored plan available at your day job.
- Unlimited Investing Options – IRAs are completely self-directed, which will enable you to have virtually unlimited investment options.
- Portable Accounts – The plans are also completely portable, and not in any way dependent upon any particular job.
- Easily Transfer Trustees – You can also transfer the account from one trustee to another whenever you like.
- No Employer Match – The contribution amounts on IRAs are much lower than what they are for 401(k) plans. And since there is no employer sponsoring it, there is no employer matching contribution either.
- Uncertain Tax Deductions – Contributions to a Traditional IRA may not always be tax deductible. The deduction is phased out above a certain income level if you are covered by a retirement plan at work.
Roth IRAs function much like traditional IRAs, except they have very different treatment for income tax purposes. Contribution amounts are the same for Roth plans as they are for Traditional IRAs, and also have the benefit of tax deferral of investment earnings, with a powerful twist.
The powerful twist is that as long as a Roth IRA has been in existence for at least five years, and you are at least 59 1/2 years old when you begin taking distributions, the withdrawals will be 100% free of income taxes.
- Tax-Free Withdrawals – If you meet certain requirements, you can start taking distributions without having to pay any income tax on the earnings in your Roth IRA account. This will provide you with a form of tax diversification, providing you with at least one source of retirement income that is not subject to income tax.
- Not Subject to RMDs – Roth IRAs are not subject to required minimum distributions (RMDs), required of other plans when you turn 70 1/2. This means your account can continue to accumulate for the rest of your life.
- No Tax Breaks – The biggest negative associated with Roth IRAs is the contributions are not tax deductible. But if you can live with this, the tax free distributions waiting at the end of the rainbow will more than make up for it.
My Retirement Account (MyRA)
Rolled out by President Obama only in 2014, “MyRA” is short for My Retirement Account. It’s a plan offered by employers, but not administered by them. It has been set up as an initial retirement plan for people who don’t have retirement plans.
- Similar to a Roth IRA – MyRA accounts have a lot in common with Roth IRAs. Money is withdrawn tax-free, though investment income will be subject to income taxes and a 10% early withdrawal penalty if taken prior to turning 59 ½.
- Low Fees and Zero Risk – The accounts are transferable from one employer to another, have no administration fees, and zero risk of principal loss due to market fluctuations.
- Low Contribution Amounts – MyRAs have low contribution levels ($6,000, just like IRAs), and do not offer an employer match.
- Not Tax Deductible – The contributions are not tax-deductible, and you have no choice as to investments.
- Limited Investment Control – All money invested with a MyRA account is in the Thrift Savings Plan (TSP) Government Securities Investment Fund.
- Rollover Requirements – The account must be rolled over to a Roth IRA once the balance reaches $50,000, or when the account is 30 years old.
This form of IRA is available for business owners who employ 100 employees or less. Since you can defer a portion of your salary each year, it’s a great way to reward your employees, much like a Traditional 401(k), but somewhat easier to setup.
- Low Maintenance – This type of IRA is also very simple to handle and the ongoing maintenance is very low. Year-end reports will be easy to understand and finalize during tax time.
- Low Fees – A SIMPLE IRA does not have large fees associated to maintain the account with a broker.
- Salary Deferral – You can defer up to $12,000 in salary each year, or $14,500 if the employee is over 50.
- Small Companies Only – A SIMPLE IRA is only allowed for companies who have 100 employees or less so if you have a business larger than this you’ll have to use a different retirement vehicle.
- Large Withdrawal Penalty – For most retirement accounts if you withdraw money before retirement age, you have to pay a 10 percent early distribution penalty. But with the SIMPLE IRA, you could be hit with a penalty as high as 25 percent of the balance.
Alternative Retirement Policies
These kinds of savings plans are not as popular as they once were, as more people have learned the virtues of buying permanent life insurance and investing in index funds, instead of life insurance policies with investment provisions.
These include permanent life insurance, variable life insurance, and a host of alternative retirement-type policies, such as annuities.
Permanent Life Insurance
- Build Cash Value – The plan builds up cash value when you make your insurance premiums.
- Tax-Deferred Earnings – Much like retirement plans, investment earnings on your policy’s cash value are tax-deferred until the money is withdrawn. This makes permanent life insurance something like an IRA with a life insurance benefit attached.
- Easily Borrow Funds – You can also borrow against the cash value of plan, much as you can with a 401(k) plan.
- No Investment Control – Investment activity in an investment-type life insurance policy is handled entirely by the company, which means you will have no control over the process.
- Low Cash Accumulation – The cash accumulation in the plan is very low early in the process. This is because life insurance policies have high fees when it comes to investment type plans.
- Sub-par Returns – The returns on permanent life insurance policies are generally sub-par. You can likely get better returns using other retirement account vehicles.
Annuities are investment contracts taken with insurance companies that function much like IRA accounts with tax-deferred earnings, and provide you with a predetermined income stream at a future date.
- No Income Limits – There are no income limits on annuity contributions, so this means they can provide a supplement of extra retirement earnings even if you’ve maxed out your retirement contributions or exceed the income limits to make traditional or Roth IRA contributions.
- Predictable Income – They can also be set up to provide you with a predictable income, either for a specific period of time, or even for the rest of your life. That’s an excellent benefit to have now that traditional defined benefit retirement plans are fast disappearing.
- Confusing Offerings – Annuities come with a wide variety of provisions that can make them confusing to the average person. They are also provided by commissioned insurance agents, which can be problematic.
- High Fees – Confusing offerings and unclear advantages of annuities also contributes to one of the biggest arguments against them: they contain high fees.
The Bottom Line
There are advantages and disadvantages to all the types of retirements accounts that you can use to grow your investment wealth, so be sure to speak to your financial advisor or accountant before making a decision.
Factor into the equation whether or not you own a business, your income limits, and the tax breaks you’ll want to take advantage of most.
Readers: What kind of retirement accounts do you have, and why? How do they compare to the others on this list?