No matter how much you like your job, we assume you’ll want to retire at some point. To do this, you need enough money to live on for the rest of your post-retirement life.
This is where a retirement plan comes in. Whether it’s through your employer or one you set up yourself, the right retirement plan will help ensure that you can support yourself after your working years are over.
As important as they are, however, retirement plans can be confusing. There are enough acronyms and numbers to make you feel like you’re back in high school algebra. But we don’t want this jargon to get in the way of your financial well-being.
That’s why we’ve created this guide to retirement plans. To start, we’ll cover what retirement plans are. From there, we’ll examine four of the most common retirement plans in detail. Finally, we’ll answer some common questions about retirement planning.
We can’t tell you which retirement plan is best for you. But by the end of this guide, you should be in a better position to decide for yourself.
Note: This article is for educational purposes only and is not investment, tax, or financial advice. Speak to a CFP, CPA, or another qualified professional for guidance on your specific situation.
What Is a Retirement Plan?
A retirement plan is a financial arrangement that helps you save for retirement. Sometimes, this is an arrangement between you and your employer (such as a 401(k) plan). In other cases, a retirement plan will be a financial arrangement that only involves you (such as an IRA).
Retirement plans determine:
- When you have to pay taxes on your retirement savings
- When you can begin withdrawing from your retirement savings
- How much you can contribute to the plan
There are other details that you probably don’t need to care about unless you’re an actuary, but that’s the basic overview.
4 Common Retirement Plans (and How They Work)
As you can see from the previous section, it’s difficult to say much useful when talking about retirement plans in general. There are simply too many cases of “it depends.”
Instead, it’s more helpful to look at some specific retirement plans. While this is by no means an exhaustive list, here’s what you need to know about the four types of retirement plans you’re likely to encounter:
401(k)
Odds are, if you haven’t heard of any other type of retirement plan, you’ve heard of the 401(k). The plan’s name refers to the part of the U.S. tax code it occupies: section 401(k).
Great, but what is a 401(k)? Broadly speaking, it’s a way that for-profit companies can offer a retirement plan to employees. And it’s also one of the most common retirement plans out there.
Here are the essential things to know about a 401(k):
- Contributions are tax-deferred – This means that any money you put in your 401(k) isn’t subject to federal income taxes until you’ve retired.
- Employers contribute money on your behalf – Once you’ve told your employer how much you want to contribute to the plan, they automatically withdraw it from your paycheck and place it into an account for you.
- Employers may match your contributions up to a certain point – While they’re not required to, some employers may offer to match your 401(k) contributions up to a certain percentage.
- You can contribute up to $19,500 annually – For 2021, you can contribute up to $19,500 to your 401(k) if you’re filing your taxes as a single person.
403(b)
A 403(b) is a way for public schools and other eligible nonprofit organizations to offer retirement plans to employees. As with the 401(k), the name of the plan refers to its section in the federal tax code.
In most respects, a 403(b) is similar to a 401(k). The differences between the two plans aren’t important to understand unless you’re the one setting up and managing your organization’s retirement benefits.
IRAs (Traditional and Roth)
The 401(k) and 403(b) are the plans you’re most likely to encounter if your employer offers a retirement plan.
If your employer doesn’t offer a retirement plan or you’re self-employed, then you’ll need to make your own arrangements. Generally, this will mean setting up an IRA.
IRA stands for “individual retirement account.” Like a 401(k) or 403(b), it’s a way to help you save enough for retirement.
Here are the main things to know about IRAs:
- You’re in charge of making contributions – While you can make the process hands-off through automatic deposits, you’re still the one in charge of making IRA contributions. There’s no employer to remember to do it for you.
- You can contribute up to $6,000 annually – For 2021, the maximum annual IRA contribution is just $6,000 for single filers. This is significantly less than the $19,500 limit for 401(k) and 403(b) contributions.
- Contributions may or may not be tax-deferred – Depending on the type of IRA you have, your contributions may or may not be made with pre-tax money. Keep reading to learn the difference.
Traditional vs. Roth IRA
When discussing IRAs, you’ll see the terms “traditional IRA” and “Roth IRA.” What’s the difference?
With a traditional IRA, you make contributions to the plan using pre-tax money. That is, your contributions aren’t subject to federal income tax until you withdraw them. Typically, you can deduct traditional IRA contributions on your taxes, which may reduce your overall taxable income (though you should discuss that with a professional to be sure).
In contrast, contributions to a Roth IRA come from post-tax money. Because of this, you won’t have to pay federal income taxes on withdrawals from your Roth IRA when you retire. However, you can’t deduct contributions to your Roth IRA when filing your federal income taxes.
So, given the choice, which plan is better? Here are a couple of things to keep in mind:
1. Roth IRAs have an income limit – If your annual income is between $125,000 and $140,000, then the amount you can contribute to a Roth IRA is reduced (assuming you’re filing as a single person).
If you make more than $140,000, then you aren’t eligible to contribute to a Roth IRA. There are no income limits for traditional IRAs, however.
2. Roth IRAs can lead to greater savings overall – While it’s true that you can deduct your contributions to a traditional IRA, those tax savings don’t get reinvested into your retirement plan unless you’re disciplined enough to do so.
Therefore, you’ll probably end up with more overall in your Roth account since there’s no temptation to spend your tax savings on a new TV. (Thanks to NerdWallet for this tip).
Note: Roth 401(k) plans do exist through some employers, though they’re less common than the traditional 401(k). Ask the person in charge of your company’s benefits if you’re interested in this option.
Once you've started earning a stable income and paid down your debts, it's crucial to start investing for the future. In my opinion, M1 Finance now represents the best option for beginning investors. The platform is free to use, allows you to open a Roth IRA (the best starting option for most students and young professionals), and allows for automated investing into index fund ETFs. Almost no other platform offers this combo.
Types of Retirement Plans FAQ
Retirement plans are a big topic, and we’ve only just scratched the surface. To round out this article, here are answers to some common questions about retirement plans:
What is vesting?
In our discussion of 401(k) plans, I mentioned that some employers will match employee 401(k) contributions up to a certain amount.
While this is a fantastic benefit that you should take advantage of when you can, there are usually some strings attached. Mainly, many employers require you to work at the company for a set period of time before their matching contributions fully vest.
“To fully vest” means that you now own the employer contributions and can take them with you when you leave the company. If you leave before your employer’s matching contributions fully vest, then you’ll lose all or part of that money.
Some generous employers vest 100% of their contributions immediately, though this is rare. More likely, your ownership of employer contributions will increase over time until you own them 100%. How long this takes depends on the specifics of your company’s retirement plan. Ask the person in charge of company benefits if you’re unsure.
What’s the difference between a pension plan and a retirement plan?
Generally, when people use the term “pension,” they’re referring to a “defined benefit plan.” This is a type of retirement plan that guarantees a specific monthly benefit at retirement.
The amount is either a specific dollar amount (such as $500 per month) or calculated using a formula that considers compensation and years of service. The employer is responsible for paying this amount regardless of what happens with their company, financial markets, etc.
While this is a great arrangement for retired employees, it’s much less common than it used to be. Most employer-sponsored retirement plans are now “defined contribution plans.”
Defined contribution plans lay out how much the employee (and, in some cases, the employer) will contribute to the plan. But they don’t guarantee the employee a specific monthly benefit when they retire. All the plans we’ve discussed in this article are based on defined contributions.
When can I access the money in my retirement account?
The goal of a retirement plan is to encourage you to save for retirement instead of spending all your money now. Therefore, retirement plans tend to stipulate when (and under what circumstances) you can access the money you’ve saved for retirement.
The precise answer to when you can access the money in your account depends on factors including your age, employment status, and life circumstances.
Generally speaking, you must be 59.5 years old to withdraw money from your 401(k) or IRA without a penalty. If you take out money before then, you’ll be subject to a 10% early withdrawal penalty in addition to any income taxes you owe on the money.
See this table from the IRS for exceptions to this rule (which are too numerous and specific to discuss here).
Don’t Let Retirement Plans Intimidate You
I know we just covered a lot of information, so I want to leave you with this: start saving for retirement now.
Which type of retirement plan you pick matters much less than starting your retirement saving as early as possible. The longer you have to save, the more time compound interest has to grow your money exponentially.
Looking to learn more about how to invest the money in your retirement account? Read this next.
Image Credits: phone, notebook, and pen on table