An overview of common retirement accounts, from Roth IRA to a 403b—and guide to which is right for you
Planning for retirement is an extremely necessary part of everyone’s life, and a foundational key to overall financial wellness. Although it’s easier to let go and live in the moment sometimes, the present moment can be made better by knowing our future is secured through the habits we engage today.
That being said, retirement investing can be a confusing road to navigate, especially for those who may be new to the process. There’s undoubtedly a lot to know, and a plethora of choices to make along the way.
So, below is an overview of some of the most common retirement accounts out there, and a guide to differentiate between these beasts.
What is a Roth 401k?
Okay, first things first. A 401k is a specific type of retirement plan that’s employer-sponsored in nature, not typically something we open ourselves as individuals. What essentially qualifies it as a retirement account is one of two tax-benefits it may offer (compared to a traditional brokerage account for investing). This brings us to the Roth aspect.
A Roth 401k differs from a traditional 401k in how its contributions are taxed. Simply put, when you contribute funds to a traditional 401k, those contributions are tax deductible from your taxable income (up to the annual limit set by the IRS). This can reduce your taxes owed, but you’ll have to pay taxes on that money later when it’s withdrawn.
So, a Roth 401k is the opposite of this. Instead of getting a tax deduction off of those contributions, you’ll pay taxes on those contributions. However, under the Roth 401k, you are not liable for additional taxes on the withdraws—neither on the contributions nor the gains.
Key characteristics of Traditional vs. Roth 401k
Roth 401ks allow tax-free withdrawals and gains
401ks have a much higher contribution limit than their IRA counterparts
Roth accounts usually make sense for investors who expect to be in a higher tax bracket later
Withdrawals of both contributions and gains from a Roth 401k can be done without penalty after age 59.5, (assuming your account is 5+ years old), if you become disabled, or by a beneficiary in the event of your death.
Withdrawals that don’t meet this criteria are subject to a 10% penalty and income taxes if the amount withdrawn exceeds the original contributions, and therefore includes any capital gains.
IRA stands for individual retirement account, and they come in two main flavors (with a couple of additional options, let’s call them “sprinkles,”) for those individuals and businesses in more unique situations. These accounts are not employer-sponsored, and as their name suggests, are opened by individuals on their own behalf.
The traditional IRA, much like the traditional 401k, allows you to deduct contributions (of up to $6,000 per year, or $7,000 if you’re age 50 or older in 2022). You’ll save money on federal income taxes now, but bite the bullet later when it’s time to cash out. The typical 10% penalty and income taxes will be levied on unqualified, early withdrawals, unless they happen to be for a specific purpose that meets certain criteria.
Again the opposite of the original, Roth IRAs allow you to pay now and play later with the taxes. The contribution limits are the same: $6,000 of earned income if you’re below age 50 for 2022, and withdrawals can be made penalty free on qualified contributions, with the only funds subject to taxes or penalties being the capital gains, or withdrawals exceeding the contributions.
SIMPLE IRAs are designed to be opened by small business owners with enterprises of 100 employees or less. They’re also pre-tax retirement accounts, meaning the same taxation and withdrawal rules as the traditional IRA apply here too. However, they have a higher contribution limit than a traditional account, coming in at $14,000 for most, and an additional $3k allowed if you’re 50+, for 2022.
SEP IRAs are yet another variation of retirement savings accounts meant for self-employed individuals and small businesses. They too are pre-tax accounts, and so the same tax and withdrawal schedule apply, yet again. The main difference here is the lofty contribution limits, which are 25% of the employee’s total compensation, or up to $61,000, whichever is the lesser.
Self-directed IRAs are a much more niche slice of the IRA pie. They’re unique accounts that allow investors to diversify into alternative assets not typically available in a traditional, or even Roth IRA, with things like real estate, precious metals, private placements, and a lot of things your normal investor wouldn’t usually care for. The contribution limits here drop back down to their normal $6,000 level, for 2022.
Other noteworthy mentions
The 403b is a retirement account that non-profit organizations and employers offer, as opposed to the more traditional 401k that for-profit businesses offer. That’s truly the most noteworthy discrepancy between these two, just that differ entities offer them.
Elsewhere, and for all it matters to you the investor, the 403b functions much the same as a 401k, with the only differences being that fewer 403b plans tend to offer employer matches, and those that do must comply with ERISA guidelines. That’s it.
Health Savings Account (HSA)
A health savings account (HSA) is probably the most unique of the bunch here. It’s not a retirement account per say, but you can withdraw from it after age 65. Primary eligibility criteria requires you to be covered by a qualifying high-deductible health insurance plan, not be covered by other alternatives like Medicare, and not be able to be claimed as a dependent on someone else’s taxes.
HSAs allow savers to contribute up to $3,650 for individuals and $7,300 for families (in 2022), and deduct those contributions from their taxable income—saving you money on taxes. You can withdraw funds from an HSA tax free, too, as long as they’re used for a qualified medical expense. (Keep those itemized receipts!)
Using an HSA and its acquired gains for retirement expenses is similar to using a traditional IRA or 401k, and is taxed just the same. If you’ve not used the accrued balance by the time you’re ineligible to contribute, you can make withdrawals, or even add it to your estate by designating a beneficiary upon death.
Bringing it all together
As we can clearly see, there’s a lot to choose from just within these two branches of retirement accounts alone, not to mention the alternatives and even more niche accounts out there.
Nevertheless, this myriad of options we have available to us to invest in our future is also a blessing. Retirement investing wasn’t always so prioritized, and things have changed a lot over the years as both governments and individuals have worked toward creating more opportunities to save for the future.
Luckily though, you’re probably already on top of those things if you’re here. We’re striving to help make your financial future brighter, and we hope you are too by checking off your to-do items in the Pocketnest app and logging a super quick 3 minutes a week to stay in the routine.