In most circumstances, the best way to save for retirement is to utilize one or more of the many retirement account options available. These include traditional or Roth IRA, traditional or Roth 401(k), 403(b), solo 401(k), SEP IRA, SIMPLE IRA and others. These accounts are usually best because you will gain certain tax advantages, have deposits protected from creditors and be encouraged not to spend the savings before retirement age because there are penalties if you do.
Each of these options has limitations, however, most notably that they each have annual contribution limits. The purpose of this article is to explain some of the differences between each type of retirement account to help you determine which is best for you or your business.
What Are My Options for Retirement Accounts?
There are many different intricacies for each type of account. The differences mostly relate to how you are employed and how much you can contribute each year. Solo 401(k)s, SEP IRAs and SIMPLE IRAs are for small business owners, 401(k) accounts are for employees of for-profit corporations and 403(b) accounts are for employees of public schools and some tax-exempt organizations. Regular IRA accounts are for anyone with earned income but are subject to some restrictions.
What Is the Difference Between a Roth and Traditional Retirement Account?
A Roth account—whether it be a Roth IRA or a Roth 401(k), Roth 403(b) etc.—is a retirement account where you pay tax on contributions in the year the money is earned (called after-tax savings), but the account grows tax-free for life as long as you don’t distribute the money before age 59.5. What’s more, you can name beneficiaries to your Roth account and distributions to them are also tax-exempt, subject to required minimum distribution rules. This is a powerful way to stretch the tax benefits into years after your life.
When Should I Utilize a Roth Account?
Roth accounts make the most sense if you expect your tax rate to be higher in retirement than your current tax rate. This is why Roth accounts are especially advantageous for young people who are working their way up to higher income years. They are also useful if you are reaching maximum contribution limits as Roth accounts allow for higher after-tax savings than equivalent traditional retirement accounts. (For related reading, see: Top 10 Mistakes to Avoid on Your Roth IRA.)
A good but not perfect gauge for whether you should utilize a Roth account is whether you qualify to make contributions to a Roth IRA (see below for Roth IRA limits). This helps because if your income exceeds those amounts you are likely looking to reduce current taxes and you would be in a relatively high tax bracket. There is no way to accurately predict where tax rates will be many years in the future, but this is a helpful gauge of when to utilize a Roth retirement account.
401(k) and 403(b) Accounts
Employees with access to these accounts can contribute up to $18,000 ($24,000 if over age 49) to their 401(k) or 403(b) plans at work. These contribution limits adjust annually with inflation. Employers have the following options for matching your contributions: (1) match 100% of contributions up to a percentage of total compensation; (2) match less than 100% of contributions up to a percentage of total compensation; or (3) match up to a certain dollar amount. The total annual contributions by or on behalf of an employee cannot exceed $54,000 for 2017, or 100% of compensation, whichever is less. (For related reading, see: Why Are 401(k) Contributions Limited?)
Solo 401(k), SEP IRAs and SIMPLE IRAs
Individual or solo 401(k), SEP IRA and SIMPLE IRA accounts are for small businesses. Solo 401(k) and SEP IRA accounts have the same contribution limits as 401(k) and 403(b) accounts—the lesser of $54,000 or net earnings.
SEP IRAs allow you to contribute up to the lesser of 25% of net earnings from self-employment or $54,000 in 2017. Solo 401(k) accounts allow you to contribute $18,000 as an employee and the employer (you) can contribute up to 20% of net earnings from self-employment, up to the contribution limit of $54,000 for 2017.
SIMPLE IRA accounts function like traditional IRAs but the contribution limit is higher—up to $12,500 in 2017. The most commonly used employer-match is on a dollar-for-dollar basis up to 3% of the employee’s compensation. Employers have some other SIMPLE IRA contribution options.
Which of these options is best for small businesses? It depends on the company size, number of employees, owner involvement and other circumstances. There is no right or wrong answer, but usually companies with more than 10 employees will opt for a SIMPLE IRA or a regular 401(k). SEP IRAs are used by companies with fewer employees and the solo 401(k) option is only available to businesses with one employee. (For related reading, see: Plans the Small Business Owner Can Establish.)
The most a person can contribute to an IRA is $5,500 for 2017 ($6,500 if age 50 or older). This is the combined limit between Roth and traditional IRAs. Single taxpayers with modified AGI over $133,000, and married taxpayers filing jointly with modified AGI over $186,000, are not able to contribute the full amount to a Roth IRA.
You can contribute up to $5,500 ($6,500 if 50 or over) to a traditional IRA regardless of your income, but the contributions may not be deductible if you or your spouse is covered by a retirement plan at work.
Traditional and Roth IRAs are great if you have no option at work, you have maxed out retirement savings at your work, or you desire a retirement account with almost unlimited investment options. They are not usually the best place to start saving because of the low contribution limits and no employer matching. (For related reading, see: Roth vs Traditional IRA: Which Is Right for You?)