You’re probably familiar with terms like 401(k) or Roth IRA, which are types of retirement plans. You might be less sure about the particular characteristics of these accounts or how they follow specific rules laid out by the Internal Revenue Service (IRS) to protect your retirement funds.
It can get even more confusing because some of these terms overlap. For example, a 401(k) retirement plan is a tax-deferred retirement plan, a defined contribution plan and a qualified retirement plan simultaneously.
Let’s look at some common types of retirement plans to help you gain greater confidence when discussing your retirement savings.
Tax-deferred retirement plan
A tax-deferred retirement plan lets you save for the future and postpone paying taxes until the money is withdrawn in retirement. Any interest you earn on your contributions is tax-deferred until retirement, when you may be in a lower tax bracket and have to pay less in taxes overall.
Many tax-deferred accounts also have the added benefit of lowering your taxable income in the year you made contributions, since you can make contributions with pre-tax money. This will hopefully leave you with a smaller tax bill next April.
Tax-deferred retirement plans can include:
- Employer-sponsored retirement plans such as 401(k), 403(b) and 457 accounts
- Traditional Individual Retirement Accounts (IRAs)
- Qualified and non-qualified retirement plans
- Tax-deferred annuities
- Health savings accounts (HSAs)
- SEP IRAs
- SIMPLE IRAs
Pros of this type of account
It reduces taxable income. Tax-deferred accounts reduce your gross income by the amount you contribute. This provides a break on your income taxes for the year in which you contribute.
Some accounts have high contribution limits. While each plan has different contribution limits and rules, you can generally save more in a tax-deferred account than in tax-free retirement accounts such as a Roth IRA.
Employers can match contributions. Employer-sponsored, tax-deferred plans often allow employers to contribute up to a certain percentage of the employee contribution to employee accounts. This is essentially free money for the account holder.
Cons of this type of retirement plan
There are early withdrawal penalties. Generally, you can’t withdraw money from a tax-deferred account before age 59½ without receiving a 10% penalty and paying taxes on the withdrawal. There are some exceptions to the 10% penalty, such as a first-time home purchase, qualified college expenses or birth or adoption expenses, but you’ll still have to pay taxes on the withdrawal.
You have to take Required Minimum Distributions (RMDs). Depending on the account, you may need to take RMDs starting at age 72 (or age 73 if you turned 72 after Dec. 31, 2022). RMDs are minimum amounts of money that account owners must withdraw annually so they don’t avoid paying taxes on their retirement funds forever.
Defined contribution retirement plan
A defined contribution retirement plan is an employer-sponsored retirement account that allows employees to save for retirement. Employers can also match employee contributions up to a percentage of the employee’s salary under this type of retirement plan.
Many defined contribution plans are tax-deferred, but some defined contribution plans, such as a Roth 401(k), allow you to save after-tax money for retirement. You don’t get the upfront tax break like you would with a tax-deferred account. However, since you’ve already paid taxes on your contributions, you won’t pay taxes on distributions or the interest earned as long as you meet specific requirements.
Examples of a defined contribution plan are:
- Employer-sponsored plans like a traditional 401(k), 403(b) or 457
- Roth 401(k)s
- SEP IRAs
- SIMPLE IRAs
- Profit sharing plans
- Employee stock ownerships (ESOPs)
Pros of this type of account
It has tax advantages. You can save pre-tax or after-tax money depending on the defined contribution account type. While each type of savings plan has benefits and drawbacks, having pre- and after-tax accounts in your retirement portfolio can help you better prepare for retirement.
Employees are in charge of their money. As the account owner, the employee can choose how much to contribute, up to the plan’s limits, and how to invest their money.
Cons of this type of retirement plan
There are no guarantees. With defined contribution plans, the burden of saving is on the employee. There are no guarantees the investments in your account will grow as much as needed to fund your retirement. You may have to work longer or live on less money in retirement depending on how your investments perform.
Defined benefit retirement plan
Unlike defined contribution plans, a defined benefit retirement plan provides a fixed, pre-established amount of money, or benefit, for employees at retirement. Employers are the primary contributors and receive a tax deduction on these plans, although some may require employees to contribute.
Defined benefit plans are also called pensions. Employees can receive a single lump sum when they first retire or choose a regular monthly payment that generally lasts for the rest of their life.
The amount an employee receives is calculated based on length of employment and salary history. This type of retirement plan provides a predictable, reliable retirement income, though they have become much less common in recent decades.
Defined benefit plans include:
- Pension plans
Pros of this type of account
You’ll have guaranteed income in retirement. As an employee, a defined benefits plan offers a set dollar amount in retirement that you can count on. You don’t have to save it yourself, and your benefit amount is generally protected, no matter what happens in the greater economy.
Employers receive tax deductions for contributions. Employers contribute to an employee’s defined benefit plans and may receive a tax deduction on their tax returns for the amount they contribute.
Cons of this type of retirement plan
Employees have limited control. As an employee, you don’t have any say in how the money in your plan is invested or how much you’ll receive when you retire.
It’s complex to set up and maintain. Defined benefit plans require a lot of administrative oversight and insurance to guarantee the company can continue to pay retiree benefits, even if the stock market crashes. Because of this, defined benefit plans are expensive and time-consuming to set up, likely the main reason it’s hard to find a pension plan outside of government entities.
Qualified retirement plan
A qualified retirement plan is another employer-sponsored retirement account, but it can be either a defined contribution or a defined benefit plan. What makes a plan “qualified” is if it meets criteria set by the IRS and the Employee Retirement Income Security Act (ERISA). ERISA, a federal law enacted in 1974, sets minimum standards for most voluntarily established retirement plans.
Qualified retirement plans can include:
- Defined contribution plans:
- Employer-sponsored plans like 401(k), 403(b), 457 accounts
- SEP IRAs
- SIMPLE IRAs
- Profit sharing
- ESOPs
- Defined benefit plans:
- Pensions
Pros of this type of account
There are ax benefits for employees and employers. A qualified retirement account offers certain tax benefits to employees and employers. Employers can take tax deductions on contributions to employee accounts, up to certain limits. Employees can make either tax-deferred contributions (to a traditional 401(k) or other tax-deferred plans) or after-tax contributions (to a Roth 401(k) or different employer-sponsored Roth account).
There are protections for plan participants. ERISA requires that employers provide plan participants with information about plan features and funding, minimum standards for participating and vesting and fiduciary responsibility to those who set up and manage the retirement plans.
Cons of this type of retirement plan
Most IRA accounts are not eligible. Since being an employer-sponsored retirement plan is a requirement to be a qualified plan, most IRAs aren’t eligible. However, there are exceptions for the SEP and SIMPLE IRAs since employers can set up and contribute to both plans for their employees. Even though they aren’t formally qualified, traditional and Roth IRAs have many of the same tax benefits as qualified accounts.
Non-qualified retirement plan
Although traditional and Roth IRAs are technically non-qualified retirement plans, the phrase usually refers to plans primarily used to reward or incentivize top executives in a company. Non-qualified retirement plans don’t have to adhere to the rules of ERISA. Plus, they don’t usually have the same tax advantages as a qualified retirement plan.
Most companies provide qualified retirement plans like 401(k)s as part of their benefits package to all employees. Since high-earners may max out their contribution limits to qualified plans or be ineligible for other plans based on income limits, employers provide non-qualified retirement plans as an additional bonus and a way to retain high-level employees.
Non-qualified retirement plans include:
- Deferred-compensation plans
- Executive bonus plans
- Split-dollar life insurance plans
- Group carve-out plans
Pros of this type of account
It’s a retention tool for high-performing employees. These plans can entice high-performing individuals to join or stay with a company.
There are some tax breaks, depending on the plan. Non-qualified plans may not have the same type of tax deductions for contributions, but many of the plans allow employees to defer taxes until they retire when they may be in a lower tax bracket.
Cons of this type of retirement plan
It’s only open to some employees. Non-qualified plans are usually only available to a few key employees who are highly compensated.
Bottom line
Understanding the essential characteristics and terminology of the different types of retirement accounts can help you manage your accounts more effectively. You likely will only need or qualify for some of these accounts. However, it’s a good idea to work with a tax or retirement professional to help you find the best funds for your specific situation.
Want to learn more about the different types of retirement plans? Listen to our rich & REGULAR podcast about it, hosted by Kiersten and Julien Saunders, below or on Apple Podcasts:
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