When employers want to give employees a tax-advantaged way to save for retirement, they may offer participation in a 401(k) plan. They may also offer employees a SEP (Simplified Employee Pension) IRA or, if the company has 100 or fewer employees, a SIMPLE (Savings Incentive Match Plan for Employees) IRA.

Individuals can open a Roth or traditional IRA separately from an employer, but only have access to a 401(k), SEP IRA, or SIMPLE IRA when offered by an employer. For the self-employed, "employer" includes an owner/employee. As their names imply, SEP and SIMPLE IRAs were designed to make it easy for employers to set up a retirement plan for employees. They have fewer administrative burdens than 401(k) plans.

Key Takeaways

  • 401(k) plans—and SEP and SIMPLE IRAs—are tax-deferred retirement savings accounts offered by employers.
  • Individuals can also set up a traditional or Roth IRA.
  • IRAs generally offer more investment choices than 401(k)s, but permitted contribution levels are much lower.

In general, you can make withdrawals from 401(k)s and the different types of IRAs penalty-free once you reach age 59½, though there are some exceptions.

401(k)s

A 401(k) is a tax-deferred retirement savings account offered by employers to their employees. Employees contribute money to their account and employers can choose to match a percentage of that contribution.

Contributions to 401(k) accounts are made pre-tax. The money is deposited in various investments, typically a line-up of mutual funds, as selected by the sponsor. The fund choices are designed to meet a specific risk tolerance so that employees may only take on as aggressive or conservative a risk with which they are comfortable.

Many 401(k)s have vesting requirements for matching contributions, but SEP and SIMPLE IRAs are 100% vested as soon as a contribution is made.

Investment income accrues and compounds tax-free. Withdrawals are taxed at the normal tax rate, as long as they are made at age 59½ or older.

Many employers are also starting to offer Roth 401(k)s. Unlike a traditional 401(k), contributions are funded with after-tax money, so they are not tax-deductible; however, qualified withdrawals are tax-free.

As of 2020, participants can contribute up to $19,500 per year to a traditional or Roth 401(k), with an additional $6,500 catch-up contribution allowed for people aged 50 and over. Additional details on contribution limits are available from the IRS.

An employee may be permitted to take loans or hardship withdrawals from a 401(k). Loan repayments are generally deducted from the employee's paycheck.

IRAs

There are several types of IRAs. An individual retirement account (IRA) (traditional or Roth) is a tax-deferred retirement savings account established by an individual person. SEP and SIMPLE IRAs are offered by employers to their employees. They are similar to 401(k) accounts in many ways, but there are some differences, chief among them contribution limits and how they work.

Unlike 401(k)s, IRAs do not generally permit loans.

IRA accounts are held by custodians, such as banks or brokerages. Unlike 401(k)s, IRAs allow account holders to own many different assets within the account, including stocks, bonds, CDs, and even real estate. Some assets, such as art, are not permitted within an IRA, according to IRS rules.

Traditional and Roth IRAs

Like 401(k)s, contributions to traditional IRAs are generally tax-deductible. Earnings and returns grow tax free and you pay tax on withdrawals in retirement. Contributions to a Roth IRA are made with after-tax dollars, but withdrawals are tax-free in retirement.

Annual contribution limits for traditional and Roth IRAs are $6,000, as of 2020, with an additional $1,000 catch-up contribution allowed for people 50 and over.

SEP IRAs

SEP IRAs have higher annual contribution limits than standard IRAs and only your employer can contribute to one. As of 2020, employers can contribute as much as 25% of an employee's gross annual salary as long as the contributions do not exceed $57,000.

SIMPLE IRAs

SIMPLE IRAs contributions work differently than SEP IRAs and 401(k)s. An employer can either match up to 3% of an employee's annual contribution or set up a non-elective 2% contribution of each employee's salary. The latter doesn't require employee contributions.

The contribution limit for employees is $13,500 in 2020, and those 50 and older can make an additional catch-up contribution of up to $3,000.

Advisor Insight

Michelle Mabry, CFP®, AIF®
Client 1st Advisory Group, Hattiesburg, Miss.

A 401(k) is an employer-sponsored plan to which you can make elective deferrals. You can contribute up to $19,500 per year, plus a $6,500 catch-up amount in 2020 for those 50 years of age and over. Employer plans typically provide some amount of matching contribution. You get to select from a menu of mutual funds or ETFs, as outlined by your individual plan. An IRA is not tied to an employer. If your income is below a certain amount and you are not covered by an employer plan, you can contribute up to $6,000 per year plus a $1,000 catch-up contribution for those age 50 and over.

The benefit of an IRA is that your investment choices are much greater and almost unlimited. The costs of each do need to be considered, and they will vary depending on the investment selection.