Retirement is often seen as a point pretty far down the road in the highway of life. However, especially for young adults, the amount of retirement accounts and options out there can be exceedingly difficult to understand. Today I will be laying out some of the most popular retirement accounts and the advantages and disadvantages associated with them.
Traditional vs. Roth
The first significant distinction to understand is the difference between Traditional accounts and Roth accounts.
- Traditional Accounts
- Traditional accounts enable you to invest pre-tax income by depositing the funds straight into the retirement account. You will eventually pay taxes as you withdraw the money from the account, but there could be a benefit to doing this that I will touch on later.
- Roth Accounts
- A Roth account is an account where you invest post-tax income and therefore do not pay taxes when you pull money out of the account
- The money in both accounts grows tax-free.
It is particularly important to understand your financial position. The best option depends on you, your financial situation and what you are comfortable with. However, you could leverage both accounts strategically to push yourself into a lower tax bracket. The inverse is also true though. If you find yourself in a lower tax bracket now than what you suspect you will be when you retire, it makes sense to go ahead and pay taxes on the money.
Employer-Sponsored Accounts vs. Personal Retirement Accounts
There are two different types of retirement accounts: employer-sponsored and personal. Employer-sponsored, as the name implies, are offered through your employer and the other are personally acquired through a financial institution.
Employer-Sponsored Accounts
There is a bigger variety in the amount of employer-sponsored retirement accounts. The accounts offered can include but are not limited to 401(k), 403(b), 457(b), Simple 401(k), and a Simple IRA. These accounts differ due to certain factors within an organization. A 401(k) is for eligible employees of private, for-profit companies.
- A 403(b) is for eligible employees of public schools, government positions, and other non-profit organizations.
- A 457(b) is designed for eligible local state and government employees.
- Simple 401(k) and Simple IRA are retirement accounts for companies that have fewer than one hundred (100) employees.
The 401(k), 403(b), and 457(b) have contribution limits which change yearly, but traditionally have higher limits than Simple IRAs and Simple 401(k).
Personal Retirement Accounts
In moving into personal retirement accounts, the accounts offered can include, but are not limited to, Individual retirement account (IRA), SEP (Simplified employee pension) IRA, Solo 401(k), and a Spousal IRA. Similarly to the employer-sponsored retirement accounts, each one of the accounts has people to whom the accounts are tailored.
- An IRA is available for anyone who has earned income during the year. There are contribution limits to the personal IRA, and these limits tend to be much less than with the employer sponsored 401(k).
- The SEP IRA is described as a mix between a 401(k) and an IRA, with a higher contribution limit than a regular IRA. The SEP IRAs are primarily utilized by individuals who are self-employed and for select employees of small businesses.
- The Solo 401(k) is for self-employed individuals and solo entrepreneurs.
- Finally, the spousal IRA allows a working spouse to contribute to an IRA for a non-working spouse. The contribution amounts are the same as with the IRA, it is just simply an account for spouses who are not working.
There are a couple of interesting notes to go along with the accounts listed above. The first and biggest is that with a Solo 401(k) you are the employee and employer in that instance, meaning that you can contribute from both the employee and employer up to the max contribution limit. The contribution limit of the SEP IRA is higher than those of the other plans. With the max contribution in 2022 being the lower of $61,000 or 25 percent of individual compensation for the year.
High-Level Summary:
Traditional vs. Roth Accounts
- Traditional – Invests pre-tax income, which lowers your current taxable income and reduces the amount of taxes you pay today. However, you will be taxed as you pull the money out in the future.
- This is the preferred option if you believe you will be in a lower tax bracket in the future, as opposed to the one you are in now.
- Roth – Invests post-tax income -> This will allow you to pay taxes on the money today and avoid taxation when you withdraw in the future. This is the preferred option if you expect to be in a higher tax bracket in the future when you withdraw the money, compared to your current tax bracket.
- Advice: Think through your planned income both now and in the future to leverage both accounts to pay the least amount in taxes
Employer-sponsored retirement accounts vs. Personal Retirement Accounts
- Employer-sponsored retirement accounts
- The type of account will be based on type and size of business.
- Contribution limits are higher than personal retirement accounts.
- Personal Retirement Accounts
- These have multiple options for self-employed individuals.
- These offer more investment vehicles than traditional employer-sponsored accounts.
- Types of accounts
- Employer-sponsored – 401(k), 403(b), 457(b), simple IRA, Simple 401(k)
- Personal retirement accounts – IRA, SEP IRA, Solo 401(k), Spousal IRA
What is the Right Option For You?
There is no cut-and-dry answer as to what is best. Depending on your situation and employer’s offerings, there will be different accounts that you will and will not qualify for. The one thing to consider is mixing and matching the traditional and Roth accounts to best leverage yourself against paying more than you need to for taxes.
About the Authors:
This article is co-written by Mac Frasier, CFPA®, CEP with Cole Arendsen, a 2024 Oakworth Intern. Arendsen is attending Auburn University working toward his MBA, Master’s of Science and Finance, and a graduate certificate in Supply Chain Planning.
More about the Oakworth Interns:
Oakworth’s internship program supports our core purpose: Helping People Succeed. The initiative of our internship program is to provide motivated students a thorough understanding and hands-on experience in the various functions within Oakworth Capital Bank. To learn more from our most recent group of Oakworth Interns click here.