How you can save for retirement: Different account options and how they work
Editorial staff, J.P. Morgan Wealth Management
- From 401(k)s and 403(b)s to individual retirement accounts (IRAs), different types of retirement accounts can offer various benefits. Understanding how they differ is crucial for tailored financial planning.
- If your employer offers a 401(k) or 403(b) with matching contributions, prioritizing those contributions can boost your retirement savings.
- Social Security, employer-sponsored plans (defined benefit and/or contribution) and personal savings accounts (including IRAs) can form a strong foundation for retirement income.
Retirement planning can feel overwhelming, especially when you’re faced with various options when it comes to retirement accounts. However, having a clear understanding of the different types of retirement accounts can help make the decision-making process easier.
Below, we’ll explore the most common types of retirement accounts, the potential advantages of each and answers to some common questions. Let’s dive in.
Common categories of retirement account products
One simple way to approach retirement planning is by learning about the common retirement account types that many individuals can choose from to save for retirement.
Employer-sponsored defined contribution plans
Examples of employer-sponsored defined contribution plans include 401(k)s (generally for private-sector employees), 403(b)s (generally for nonprofit and education sector employees) and 457(b) plans (in particular, for government workers). These plans may allow you to contribute a portion of your pre-tax and/or after-tax income and may come with employer matching contributions.
Individual retirement accounts (IRAs)
IRAs, such as traditional IRAs and Roth IRAs, are accounts you open on your own (outside of an employer). They come with specific contribution limits and tax advantages, making them an important part of many people’s retirement strategies. Generally, individuals need to have earned income to contribute to these accounts.
Retirement accounts for self-employed individuals
Self-employed individuals have a number of retirement saving accounts available to them that others may not. Those include solo 401(k) plans and SEP IRAs.
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Considerations to make when it comes to choosing the right retirement savings accounts
Let’s take a look at some of the most popular retirement savings accounts. Understanding each will help you choose the retirement options that best fit your needs.
Employer-sponsored plans
As the name suggests, employer-sponsored plans are offered by employers. In most cases, you can contribute a percentage of income (pre-tax and/or after-tax, depending on the plan) toward your retirement. Your employer may also match your contribution up to a certain percentage.
401(k) plans
Typically offered by private-sector employers, 401(k) plans allow employees to contribute a portion of their income, sometimes with employer matching up to a specified limit. Plans may allow for contributions to be made on a pre-tax (traditional 401(k)) and/or after-tax (Roth 401(k)) basis.
- Advantages: These include tax benefits, potential employer matching and high contribution limits.
- Considerations: Withdrawal rules can be strict, and early withdrawals typically come with penalties.
403(b) plans
This type of plan may be offered by nonprofit organizations, public schools and certain religious institutions. Some employers may also offer a matching contribution up to a specified limit.
- Advantages: These offer benefits comparable to 401(k) plans.
- Considerations: In a similar vein to 401(k) plans, withdrawal rules can be strict, and early withdrawals typically come with penalties.
Governmental 457(b) plans
These plans may be provided by state and local government agencies. Participants may be able to make contributions in pre-tax and/or after-tax dollars, and some plans may offer employer matching.
- Advantages: These accounts offer tax-deferred growth, and withdrawal taxation rules can be more forgiving for those who leave their employers. For governmental 457(b) plans, withdrawals can generally be made without an early withdrawal penalty at any age if you have left your employer (certain exceptions may apply).
- Considerations: Contribution limits for 457(b) plans are similar to those for 401(k)s and 403(b)s. Additionally, governmental 457(b) plans allow for rollovers to other eligible retirement plans/accounts, such as 401(k)s, 403(b)s and IRAs.
Individual retirement accounts (IRAs)
IRAs are retirement savings accounts that you can set up for yourself. Depending on the account that you choose, your contributions will either be tax-deductible in the year you make the contribution and your withdrawals will be taxed as regular income, or you won’t receive a tax deduction in the year you make a contribution but your withdrawals may be tax-free.
Both options come with their own advantages and considerations.
Traditional IRAs
These are offered to individuals through financial institutions such as banks or brokerages. While anyone with earned income can contribute, your ability to deduct contributions from your taxable income may be limited if you or your spouse are covered by a retirement plan at work. Earnings are tax-deferred, meaning you don’t pay taxes on investment gains until you withdraw the money.
- Advantages: They include potential tax deductions, plus a wide range of investment choices.
- Considerations: Traditional IRAs come with annual contribution limits, deductibility rules and required minimum distributions (RMDs) that start at a certain age. Early withdrawal penalties in most cases also apply.
Roth IRAs
Individuals can open a Roth IRA through many financial institutions. Contributions are made with after-tax dollars, and earnings can be withdrawn tax-free once you meet certain requirements.
- Advantages: Roth IRAs offer tax-free growth and withdrawals, no RMDs for original account owners and broad investment choices.
- Considerations: You must meet certain income requirements to contribute; there’s an annual contribution limit; and early withdrawal penalties generally apply.
Self-employed or small-business owner retirement accounts
If you’re self-employed, there are several retirement account options available that you can use to set aside retirement money for yourself. Those options include:
Solo 401(k) plans
If you’re a self-employed individual, a solo 401(k) works like an employer-sponsored 401(k), allowing you to make contributions both as yourself and your business. The plans are designed for small-business owners who don’t have employees beyond themself and their spouse.
- Advantages: Traditional solo 401(k)s allow you to set aside pre-tax income. Roth solo 401(k)s, on the other hand, allow you to set aside after-tax income, and qualified withdrawals are tax-free (similar to Roth IRAs).
- Considerations: You can only establish this type of plan if you have no employees other than yourself and a spouse. Like with a traditional 401(k), you also need to pay taxes when you withdraw assets from a traditional solo 401(k). In contrast, if you meet certain requirements, you won’t need to pay taxes when you withdraw assets from a Roth solo 401(k).
SEP IRAs
SEP IRAs are for self-employed individuals and small-business owners.
- Advantages: SEP IRAs offer higher contribution limits compared to traditional IRAs and Roth IRAs. They’re also designed to have fewer administrative requirements.
- Considerations: Only employers can make contributions, and contributions must be made for each eligible employee. If you are a small-business owner versus a self-employed individual, this is worth noting.
Retirement income: The “three-legged stool”
Most people rely on three sources of income when they retire, sometimes referred to as the “three-legged stool.”
They are:
- Social Security: Social Security is a U.S. government-offered benefit based on your earnings record (i.e., how much you’ve earned and contributed to the Social Security program over the course of your working life).
- Employer-sponsored plans (i.e., a pension or defined contribution plan): This could be a traditional pension (a “defined benefit plan”) or a 401(k), 403(b), etc. (which are known as “defined contribution plans”).
- Personal savings and investments: These can include IRAs, brokerage accounts and other investment vehicles.
Balancing these three components can be important to sustaining a comfortable lifestyle in retirement.
Can you have multiple retirement accounts?
When it comes to saving for retirement, the best option(s) for you usually depend on your employment situation and financial goals. Many investment experts recommend utilizing a combination of investment vehicles.
If your employer offers a 401(k) or 403(b) plan, not taking advantage of the potential for employer contributions means that you’re essentially leaving money on the table.
At the same time, having a traditional or Roth IRA allows you to contribute to your retirement independent of your employer. This can be especially useful if you’re in a career where you may have extended periods between jobs or one in which you may choose to be self-employed at some points.
In addition, having an IRA means that you may have the option to roll money from your 401(k) into your own account. This may give you greater control over your investments in the long term.
As long as you follow the applicable annual contribution rules, you may be able to contribute to both at the same time.
Ultimately, if you’re given the opportunity through your employer, you may want to try to focus on capturing the full employer match, as it directly increases your retirement savings, and then make a decision if it makes sense for your goals to have another retirement account, too.
The bottom line
Choosing the right combination of retirement accounts matters when it comes to securing your financial future. Periodically reviewing your strategy and adjusting as needed can help you to stay on track to meet your retirement goals and enjoy the peace of mind that comes with a solid financial foundation.
Understanding the different types of retirement account options – from 401(k)s and 403(b)s to IRAs – will help you create a well-rounded strategy. Make sure you’re also factoring in things like contribution limits, tax advantages, fees and potential employer matches.
If you’re unsure which type of retirement account best aligns with your financial goals, consider consulting with a financial advisor and your legal and tax professionals.
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Editorial staff, J.P. Morgan Wealth Management
