You’re familiar with the terms “IRA,” “401(k),” and “Roth IRA,” but to you they all just mean saving for retirement. This post is meant to be a quick guide to the differences between various retirement accounts and plans.
Short for “individual retirement account.” IRAs allow people to save up for retirement by investing a portion of their earnings into the various funds within the account with the hopes of those funds earning a profit.
Traditional IRA: A traditional IRA allows people to put away pre-tax earnings. When the investor retires, the distributions are then subject to income tax. The goal here is to be in a lower tax bracket when you retire than you were when you were making those pre-tax contributions.
Roth IRA: A Roth IRA allows people to put away after-tax earnings. When the investor retires, the distributions are typically not subject to income tax. This can be advantageous to people who expect to be in a higher tax bracket in retirement than they were when they were making those after-tax contributions.
SEP IRA: Otherwise known as a Simplified Employee Pension, a SEP IRA is a type of traditional IRA. SEP IRAs are best for very small companies, and sole-proprietors. Small business owners are able to establish SEP IRAs for employees, allowing the employer to make deductible contributions for participating employees.
SIMPLE IRA: SIMPLE stands for Savings Incentive Match Plan for Employees. SIMPLE IRAs are great for companies with 100 or less employees. As opposed to the SEP IRA, both employees and their employer can make contributions to the account.
A 401(k) plan is a retirement vehicle set up by employers for employees. Similar to the IRA, 401(k) plans allow people to save up for retirement by investing a portion of their earnings into the various funds within the account with the hopes of those funds earning a profit. These plans also have traditional and Roth versions.
If you’re an employee of tax-exempt organizations, you may have a 403(b) plan. These are similar to 401(k) plans in that employers set them up for employees, and employees can make salary deferral contributions.
A profit-sharing plan is exactly what it sounds like – a company decides to share a portion of its profit with employees. Companies can decide how much they want to contribute to each employee; however they have to be able to prove that the profit-sharing plan does not favor higher-paid employees over others. Like with other retirement plans, there are restrictions on the withdrawals.
This is another employer-sponsored plan. Companies use a formula to calculate benefits for each employee. The employer makes all investment decisions, and therefor is responsible for all investment risk. Again, there are restrictions on when and how employees can withdraw funds.
Employee Stock Ownership Plans (ESOP)
Another way people can save for retirement is if their employer offers an ESOP. There are different variations of ESOPs, but essentially this is when an employee invests in the stock of his or her employer. Then, when the employee retires or resigns, the shares are sold back to the company.
Although this overview is brief, it does portray the differences in various retirement plan options. The key: start saving early, with a goal of investing 15% of your household income into one of the above retirement vehicles. Often time’s employer sponsored plans offer matching contributions – this is free money – take advantage of it, and let time be the fuel behind compound growth.
You should consult your employer and your financial adviser to see if you’re making the most of your retirement plan!
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