Saving for retirement can seem intimidating, to begin with. It takes yet another slice out of your paycheck and simply thinking about how much you need to save can seem overwhelming.
Then, once you finally decide to start saving, you’re hit with another problem: a seemingly endless array of confusingly-named options. Roth? Traditional? IRA? 401(k)? 403(b)? TSP? What do they all mean? Which one is even the right choice for me? Let’s dig into what some of the most common options are, whether you’re eligible and for what situations each account type is useful.
The different types of retirement plans
This is not an exhaustive list of every type of retirement plan you may find, but covers most of the common ones.
A Roth IRA is an individual retirement account that you can open at most brokerages and banks, meaning you have a wide array of options when choosing the best Roth IRA for you. You deposit money directly from your checking account into a Roth IRA, then once the money is in the account, you decide how that money is invested. Most Roth IRAs offer a very wide array of investment options.
You can withdraw your contributions to a Roth IRA at any time without penalty. You can withdraw your gains without penalty in a Roth IRA starting at age 59 1/2, provided you’ve owned the account for at least five years, and you will owe no income taxes on the gains. You’re only allowed to contribute $6,000 a year to this account ($7,000 if you’re age 50 or older), and there are some income limits that restrict some high-income earners from being able to use a Roth IRA.
When to use a Roth IRA: If you anticipate having significant taxable income once you hit retirement age, usually because you have significant money in a workplace retirement plan, a pension, or other investments, a Roth IRA is a great choice.
A traditional IRA is similar to a Roth IRA in many ways. You can open it at most brokerages and banks (giving you many options when selecting the best traditional IRA for you), you fund it from your checking account, and you decide how money is invested within the account. You’re also restricted to $6,000 per year in contributions and there are income limits that restrict your eligibility for some of the tax benefits discussed below.
The big difference with a traditional IRA compared to a Roth IRA is in taxes. When you contribute to a traditional IRA, your contributions are tax-deductible, meaning that you can claim them for a reduction in your income tax bill if you’re not already taking the standard deduction. However, when you withdraw money from a traditional IRA in retirement, you have to pay income taxes on all money withdrawn.
When to use a traditional IRA: A traditional IRA is a good option if you believe that you will be in a very low tax bracket when you retire. If you anticipate not having a lot of savings for retirement beyond Social Security and Roth savings, it’s a good option.
A 401(k) is a retirement plan offered through your workplace. It is usually funded through direct deduction from your paycheck. Once the money is in the account, you have an array of investment options to choose from. 401(k)s come in both traditional and Roth flavors, with traditional contributions coming out before taxes are taken out (thus reducing the taxes you pay this year) and Roth contributions coming out after taxes are taken out (thus having no impact on this year’s taxes). Some employers match your contributions.
When you retire, the money you withdraw from a traditional 401(k) is taxed like normal income, whereas money you withdraw from a Roth 401(k) isn’t taxed at all. So, as with IRAs, choose the Roth option if you anticipate continuing to earn taxable income when you retire and choose the traditional if you expect this to be your only form of income aside from Social Security in retirement.
When to use a 401(k): A 401(k) plan is a great option if your workplace offers any sort of contribution matching. If it does, you should get every dime of the match. If not, it is a good option for contributing more to your retirement if you want to contribute more than the income limit on an IRA or if you’re above the income level to receive the tax benefits of an IRA.
A 403(b) is almost exactly like a 401(k), except it is offered by nonprofit employers. From the perspective of the individual investor, they function identically. You contribute money directly from your paycheck, make investment options within the account, and then withdraw money from the account once you retire.
When to use a 403(b): A 403(b) plan is a great option if your workplace offers any sort of contribution matching. If not, it is a good option for contributing more to your retirement if you want to contribute more than the income limit on an IRA or if you’re above the income level to receive the tax benefits of an IRA.
A 457(b) plan is another type of retirement plan offered by some nonprofits and state governments. They may offer just a 457, a 403(b), or both.
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In most regards, they operate just like a 403(b): money comes from your paycheck, you make investment choices, and you make withdrawals in retirement.
What if your workplace offers both a 403(b) and a 457? A 403(b) is better if you plan to be an employee for a long time, as it raises the contribution limits for long-time employees. A 457 is better if you are close to retirement, as it raises contribution limits for people close to retirement. However, you can use both, and the contribution limits are independent of each other.
When to use a 457: A 457 plan is a great option if your workplace offers any sort of contribution matching, and as a place to put additional contributions.
FERS is the Federal Employees Retirement System, which provides both a basic annuity as well as access to an additional plan. TSP is short for Thrift Savings Plan, which works much like the 401(k), 403(b), and 457 plans.
You contribute to the plan directly from your paycheck, it comes in Roth and traditional varieties, you choose investment options once you’ve contributed, and you make withdrawals in retirement. A Roth TSP means that your contributions don’t reduce your taxes now, but your withdrawals in retirement are tax-free, while a traditional TSP means your contributions reduce your taxes today, but your withdrawals in retirement will be taxed.
The big advantage of a TSP plan is that your contributions are matched. The government contributes 1% of your salary automatically to your plan regardless of what you contribute and will match up to 4% more of your salary if you contribute up to 5% of your own. In other words, if you contribute 5% of your salary, that money will double.
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The biggest catch with TSP is that you are limited to the investment options the plan makes available. The options are generally highly regarded, but fairly limited in number.
When to use a TSP/FERS account: If you are a federal employee, you should contribute 5% of your salary at a minimum to your TSP account. That money will double, as the federal government will match it dollar for dollar.
A SEP-IRA is a Simplified Employee Pension plan is a simple tax-deferred retirement plan available to anyone who is self-employed, owns a business or employs others. It is often used by freelancers to save for retirement. If you’re self-employed, you’re allowed to contribute up to 20% of your net business income to the plan, up to a total of $57,000 a year in contributions.
When to use a SEP-IRA: This is a great option to use if you are self-employed or do freelancing work, particularly if you earn a lot of money in self-employment.