This story originally appeared on NewRetirement.
Saving for retirement is not a one-size-fits-all proposition. Whether you use an IRA, a 401(k), one of the many other options or a combination of several plans, the best retirement plan for you depends on your employment status and how much you’re able to contribute.
Sometimes when we talk about the best retirement plans, we are referring to the various accounts used for saving money for retirement. Other times we are talking about all the various issues related to having a secure retirement — knowing how much you will need, what to do about Social Security, housing, budgets and more.
If you need a detailed strategy for figuring out the financial details of your life after retirement, then you might want to use the NewRetirement retirement calculator, named a best retirement calculator by the American Association of Individual Investors (AAII).
If you are trying to figure out which kind of 401(k), IRA or other plan is best for you, keep reading.
Individual retirement account (IRA)
One of the best retirement plans regardless of employment status is an individual retirement account. An IRA is basically a savings account with big tax breaks, allowing you to sock away cash that grows tax-free.
For 2020, you can contribute up to $6,000 to an IRA. The catch-up contribution for people 50 or older is $1,000 per year, so you can save up to $7,000 with tax advantages.
You may be able to claim a deduction on your federal income tax return for the amount contributed to an IRA. If you are covered by a retirement plan at work, the deductible portion of your contribution depends on your filing status and your modified adjusted gross income (MAGI).
This table from the IRS can tell you if your deduction will be limited. A deduction is allowed in full if you are not covered by a retirement plan at work.
If you make an IRA contribution that is not deductible, you’ll still get a tax benefit eventually. Non-deductible contributions can be withdrawn tax-free in retirement. You’ll keep track of the non-deductible contributions on Form 8606 of your individual tax return.
A Roth IRA is similar to a traditional IRA except that the tax benefits are realized when you withdraw the money rather than when you put it in. Contributions to Roth IRAs are never deductible, but the contributions and earnings can be withdrawn tax-free in retirement. That’s a pretty nice perk if you expect to be in a higher income tax bracket in retirement.
Like the traditional IRA, contributions to a Roth are limited to $6,000 for 2020 ($7,000 if you’re age 50 or older).
Contributions to a Roth are also limited by your MAGI. If you’re a married couple filing jointly, your MAGI must be under $203,000 for the tax year 2019 and $206,000 for the tax year 2020.
Pensions are a great vehicle for retirement savings — if you can get one through your employer.
Previous generations tended to stay with the same company for many years — perhaps even their entire career. In exchange, their employers provided for their retirement years with pensions, a guaranteed amount of monthly income from retirement until death.
Unlike a 401(k) plan, which will be discussed next, the income you’ll receive in retirement from a pension is not affected by the performance of the stock market. All investment risk is on the plan provider.
Today, company-sponsored pension plans are practically unheard of. Pensions are both more expensive and riskier to employers than a 401(k) plan.
A 401(k) plan is primarily funded through employee contribution via pre-tax payroll deductions. Contributed money can usually be placed into numerous investments, including stocks, bonds, mutual funds and ETFs, depending on what options the employer offers through the plan. Like IRAs, the investments in a 401(k) are able to grow tax-free, but they are taxable when funds are withdrawn in retirement.
There are two features of 401(k) plans that make them a better option for retirement savings than IRAs. First, contribution limits for 401(k) plans are higher. For 2020, you can contribute up to $19,500 to a 401(k) plan, with an additional “catch-up” contribution limit of $6,500 if you’re age 50 or older.
Second, many employers offer matching contributions, which equals “free money” for plan participants. If your employer offers matching contributions, make sure you’re at least contributing enough to get the full match, otherwise you’re not taking full advantage of your total compensation package.
Some employers also offer Roth 401(k) options. If you opt for the Roth version, your contributions will be made with after-tax dollars and won’t be taxed upon withdrawal.
A 403(b) plan is similar to a 401(k) in that it allows employees to make pre-tax contributions into a retirement plan, but these plans only available for employees at a church, school, hospital or other nonprofit organization.
While contribution limits are the same as 401(k) plans, investments in the 403(b) plan are limited to annuities and mutual funds. For a more in-depth look at 403(b) plans, check out this article.
A SIMPLE IRA is a retirement plan that may be established by employers, including self-employed individuals. Employees are able to make pre-tax contributions to the plan, which are taxable when they’re withdrawn in retirement.
If your employer offers a SIMPLE IRA, they are required to make either matching contributions to the plan or nonelective contributions, which are paid to each eligible employee regardless of whether the employee contributed.
SIMPLE IRAs are usually the plan of choice for small employers since they are easier to administer.
Like a 401(k), employees can make pre-tax contributions to a SIMPLE IRA, but the contribution limits are lower. For 2020, employees can contribute $13,500 to a SIMPLE IRA, and after age 50 can contribute an additional $3,000 per year in catch-up contributions.
A simplified employee pension (SEP) IRA allows a small-business owner to make tax-deductible contributions on behalf of eligible employees, including the business owner. A SEP is available to employers of any size and allows for contributions of up to 25% of each employee’s pay, up to a limit of $57,000 in 2020.
They are generally easy to establish and involve very little paperwork, but only the employer can contribute to the SEP. Employees are not able to make pre-tax contributions. For sole proprietors, this is not an issue, but business owners with employees may want to consider a 401(k) plan in order to allow employees to contribute.
A solo 401(k), also known as an individual 401(k), is very similar to a traditional 401(k) plan, but it’s strictly for sole proprietors who have no employees (other than a spouse who works for the business). Like a traditional 401(k), a solo 401(k) can come in both traditional and Roth versions.
Solo 401(k)s are ideal if you want to sock away large sums of money since you can save for retirement both as an employer and as an employee. As an employee, you can contribute the standard 401(k) contribution limit of $19,500 in 2020, or $26,000 in 2020 if age 50 or over. As your own employer, you can contribute an additional 25% of compensation, up to a maximum of $57,000 including your employee contributions.
Since these amounts are discretionary, you can save the maximum in profitable years and reduce or even eliminate contributions in leaner years.
The downside to a solo 401(k) is the amount of administration required. Solo 401(k) plans require more paperwork than SEP IRAs and if your account balance exceeds a certain amount, you’ll have to file a separate tax return for the plan, which can increase your tax preparation costs. A solo 401(k) also comes with setup charges and annual fees, so they’re more expensive than a SEP IRA.
Defined benefit plan
A defined benefit plan is essentially a pension because it allows for a predetermined benefit at retirement regardless of market fluctuations.
While large-employer pensions are all but extinct, some self-employed and small-business owners choose to start defined benefit plans in order to save aggressively for retirement while realizing significant tax benefits.
A defined benefit plan is funded with employer contributions only and must be funded annually. Annual contributions are calculated based on several factors, including age, compensation and retirement age. If you have employees, you must contribute for all eligible employees. Contributions are 100% tax-deductible and earnings grow tax-free but are taxable when withdrawn.
Defined benefit plans work best for self-employed people age 50 or older who can make annual contributions of $80,000 or more for at least five years and have few, if any, employees. The plan takes a while to set up and must be established by the end of your business’ fiscal year (usually December 31).
While defined contribution plans have some of the highest contribution limits, there are also substantial costs and administrative requirements based on the terms of your plan, including annual actuarial calculations, required annual funding and filing fees for IRS Form 5500.
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