Retirement accounts are tax-advantaged investment accounts. Your money grows with tax-free compounding until retirement when you can start taking qualified distributions at the age of 59½. Depending on the type of retirement account, you could either get a tax benefit when you deposit money or when you withdraw.
There are many different types of retirement account. Some are designed for salaried employees at companies, some are designed for business owners and the self-employed, and others are available to anybody with earned income. Each retirement account has different tax benefits, contributions limits, investment options and withdrawal rules.
Who can open a retirement plan?
The eligibility rules are different for each type of retirement plan.
- 401k: In order to have a 401k, you need to work at a company that sponsors a 401k plan for their employees.
- Traditional IRA: Anyone with earned income can open and contribute to an IRA. There are no income limits.
- Roth IRA: Anyone with earned income can open and contribute to a Roth IRA. However, you cannot contribute if your income is over $144,000 for 2022 and $153,000 for 2023.
- Solo 401k: Any business owner or self-employed individual can open a solo 401k if they have any form of business activity with zero full-time employees that work over 1,000 hours per year (excluding spouse).
- SEP IRA: Any business owner can open a SEP IRA regardless of employee count.
- SIMPLE IRA: Any business owner with less than 100 employees can open a SIMPLE IRA.
Types of tax-advantages
Almost all retirement accounts have tax-free compounding. With a regular investment account, you have to pay capital gains tax whenever you sell assets for a profit. For example, if you invested $10,000 into Tesla stock and it grew to $100,000, you would owe capital gains tax on the $90,000 in profit. With a retirement account, profits go straight back into your account and it can all be reinvested, allowing your retirement nest egg to grow significantly faster and larger.
Traditional vs Roth
Some, not all, retirement plans come with two different options: Traditional and Roth (for example, there’s a traditional IRA and a Roth IRA).
Traditional retirement accounts give you tax benefits when you deposit money into your plan and Roth retirement accounts give you tax benefits when you withdraw money from your plan.
- Traditional retirement accounts: You get a tax break by getting a tax-deduction when you contribute to your plan. Withdrawals in retirement are taxed as regular income.
- Roth retirement accounts: You get no tax breaks when you contribute. Withdrawals in retirement are completely tax-free.
When both types of accounts are offered, you get to choose whether you want to get a tax break at the time of contribution, or pay taxes now and pay no taxes later in retirement.
Types of retirement plans
Two of the most common retirement plan types are the IRA and 401k. As a business owner or freelancer, you also have a few additional options, the main ones being the solo 401k, SEP IRA, and the SIMPLE IRA.
- A 401k is an employer sponsored retirement account. You can only get a 401k plan if you work at a company that offers a 401k to their employees. If you have a 401k, you have the option to contribute a portion of your salary, where it gets invested into mutual funds. The downside of a 401k is that you don’t get many investment options and can usually only pick from around a dozen mutual fund selections. A 401k has a traditional and Roth option, but not all employers will offer a Roth account included in their plans.
- An IRA is an individual retirement account. You don’t need an employer to sponsor the plan, it’s available for anyone with earned income. An IRA has more investment options than a 401k, but contribution limits are much lower. With an IRA, you can choose between a traditional IRA and a Roth IRA.
- A solo 401k is a 401k plan designed specifically for self-employed individuals and business owners with no employees. This is perhaps the most tax-advantaged retirement plan available since it has the highest contribution limits, a big Roth option, and no income or investment restrictions. The only downside is that you’re not allowed to have any full-time employees other than your spouse.
- A SEP IRA is the next best retirement plan for business owners and self-employed individuals. While a solo 401k doesn’t let you have any employees, you’re allowed as many employees as you want with a SEP IRA. However, due to the contribution rules of a SEP IRA, it’s best for business owners with only a handful of employees. It doesn’t come with all the benefits of a solo 401k, but it has much higher contribution limits than something like an IRA. A SEP IRA has no Roth account.
- A SIMPLE IRA is a type of employee retirement plan for small business owners with fewer than 100 employees. It’s a cheaper, simpler alternative to offering a 401k plan at your business.
Let’s go through each of the accounts in more detail below.
A 401k is an employer sponsored plan. The only way to get a 401k is to work for a company that sponsors a 401k plan. Some companies will also offer employer match contributions where your employer will match your contributions, dollar-for-dollar or 50 cents on the dollar, up to a specific percentage of your salary. For example, a company might offer a 5% employer match, which means they’ll match your contributions up to 5% of your salary. If you make $100,000, you can get up to $5,000 in employer match contributions.
How it works: Employees can contribute a portion of their salary into their plans. The money gets invested and grows tax-free until you choose to take distributions in retirement. Some employers will also offer a Roth version of the 401k. Employees can choose between contributing to a traditional 401k and Roth 401k.
- Contributions to a traditional 401k are made in pre-tax dollars and get deducted from your taxable income. Withdrawals in retirement are taxed as regular income.
- Contributions to a Roth 401k are made in after-tax dollars. You pay income taxes on the money now, but withdrawals in retirement are tax-free.
Investment options: Investment options are limited to whatever your 401k plan provider offers. Usually, you can choose between 8 to 12 mutual funds. You can’t invest in individual stocks, or alternative assets like crypto, real estate, and private equity.
Contribution limits: The 401k contribution limit is $20,500 for 2022 and $22,500 for 2023. If you’re at least 50 years old, you can contribute up to $27,000 for 2022 and $30,000 for 2023.
Withdrawal rules: You can start to take qualified distributions at the age of 59½. Any withdrawals made from your account before the age of 59½ are subject to an early distribution penalty of 10% plus income taxes on the withdrawn amount.
Roth 401k withdrawal rules: In addition to being over 59½ years old, your Roth 401k account must be at least 5 years old (ie. it must have been 5 years since your first contribution) in order to take qualified distributions without penalties.
RMD: A 401k has required minimum distributions. Once you reach the age of 72 years old, you’re required to start taking distributions from your account each year, until your account is emptied. Refer to the RMD table to calculate your RMD amounts.
IRA (Traditional and Roth)
How it works: When you open an IRA, you get to choose between a traditional IRA and a Roth IRA, or open and contribute to both at the same time.
- A traditional IRA works the same way as a traditional 401k. Your contributions are made in pre-tax dollars and gets deducted from your taxable income for the year. Withdrawals in retirement are taxed as regular income.
- A Roth IRA also works the same way as a Roth 401k. Your contributions are made in after-tax dollars, you don’t get any tax deductions, but your withdrawals in retirement are tax-free.
Investment options: You have more investment options with an IRA than with a 401k. Instead of being limited to just a handful of mutual funds offered by your employer’s plan provider, you can invest in individual stocks, mutual funds, bonds, and ETFs. You can also choose to open a self-directed IRA, which opens up the door to invest in alternative assets like real estate, crypto, and private equity.
Contribution limits: The contribution limits for an IRA are much smaller than other retirement accounts. The IRA contribution limit is $6,000 for 2022 and $6,500 for 2023. If you’re at least 50, you can contribute up to $7,000 for 2022 and $7,500 for 2023. If you’re contributing to both a traditional and Roth IRA, your total contributions must not exceed the yearly contribution limit.
Roth IRA income limits: A traditional IRA does not have any income limits, and anyone with earned income can make contributions. A Roth IRA, on the other hand, does not let you contribute at all if your income is too high. The income limit of a Roth IRA is $144,000 for 2022 and $153,000 for 2023. If you make more than the limit, you’re not eligible for Roth IRA contributions.
Withdrawal rules: You can start to take qualified distributions from your account when you reach the age of 59½. Early withdrawals are subject to a 10% penalty plus income taxes.
Roth IRA withdrawal rules: The Roth IRA withdrawal rules are a little bit different. You can withdraw your contributions from your account at any age without penalties or taxes. To withdraw any earnings, you must be at least 59½ years old and your Roth IRA must be at least 5 years old (ie. it must have been 5 years since your first contribution).
RMD: A traditional IRA has required minimum distributions. You’re required to start taking distributions once you reach the age of 72. A Roth IRA has no RMD.
A solo 401k is perhaps the best retirement plan because it offers the most tax advantages and flexibility in what you can invest in. To be eligible for a solo 401k, you must have any form of business income and no full-time W-2 employees that work over 1,000 hours in your business per year (excluding your spouse). All business entities are eligible and there are no income limits.
How it works: With a normal 401k, you get to make contributions as an employee and your employer might decide to offer employer match contributions. With a solo 401k, you get to contribute as both the employer and the employee. The best solo 401k plan providers offer a Roth account, the option to take a solo 401k loan, the ability to do rollovers, and the ability to do a mega backdoor Roth solo 401k.
Investment options: With a solo 401k, you can invest in whatever asset you want. You’re not restricted by the options that your plan provider gives you. Instead, you get checkbook control over your account. When you open a solo 401k, separate bank and brokerage accounts are created for your solo 401k trust. As the trustee of the account, you get to control the checkbook and make investments directly. The only things the IRS does not let you invest in are collectibles (like art and rare coins) and life insurance investments.
Contribution limits: The solo 401k has the highest contribution limit of any retirement plan. You can contribute up to $61,000 for 2022 and $66,000 for 2023. If you’re at least 50 years old, you can contribute up to $67,500 for 2022 and $73,500 for 2023.
Remember that you get to contribute as both the employee and the employer. Here’s how that gets broken down:
- As an employee, you can contribute the same amount as you could to a normal 401k. The limit is $20,500 for 2022 and $22,500 for 2023. If you’re at least 50, you can contribute up to $27,000 for 2022 and $30,000 for 2023.
- As an employer, you can contribute up to 25% of your compensation if your business is incorporated, and up to 20% of your compensation if your business is not incorporated.
- The total contributions between employee and employer must not exceed the yearly contribution limit.
Withdrawal rules: The solo 401k withdrawal rules are the same as a 401k and IRA. You can start to take distributions from your account without penalties when you reach the age of 59½. Early withdrawals are hit with a 10% penalty and income taxes.
Roth solo 401k withdrawal rules: In addition to being over 59½ years old, your Roth solo 401k account must be at least 5 years old (ie. it must have been 5 years since your first contribution) in order to take qualified distributions without penalties.
RMD: A solo 401k has required minimum distributions for both traditional and Roth accounts. You must start taking distributions from your account when you reach the age of 72.
SEP IRA stands for Simplified Employee Pension and, like the solo 401k, is a retirement plan for business owners. With a SEP IRA, you’re allowed to have as many employees as you want. However, it’s best designed for employers with just a handful of employees due to the contribution rules.
How it works: With a SEP IRA, only employers can contribute to the plan. Employees are not allowed to make contributions; they can only receive contributions from their employer. Employers are obligated to make equal percentage contributions for every eligible employee. For example, if you run a business with 10 employees, and you decide to contribute 10% of your compensation to your SEP IRA, you must also contribute 10% of every eligible employee’s compensation into their SEP IRAs.
Because of this rule, a SEP IRA can get expensive if you have too many employees. Fortunately, employers can decide how much gets contributed each year, and can even skip contributions entirely if they have a down year. All contributions are tax-deductible.
Employee eligibility: Any employee who is at least 21 years of age, worked for your business for 3 out of the last 5 years, and earned at least $650 for 2022 and $750 for 2023 is considered an eligible employee and must receive equal percentage contributions.
Contribution limits: Employers can contribute up to 25% of their compensation up to $61,000 for 2022 and $66,000 for 2023. There are no catch-up contributions for people age 50+ with a SEP IRA.
Investment options: The investment options of a SEP IRA are similar to a traditional or Roth IRA. You have more options than a corporate 401k, but you’re still limited to traditional assets like stocks, bonds, mutual funds, and ETFs.
Withdrawal rules: You can start to take qualified distributions at the age of 59½. Early withdrawals are hit with a 10% penalty plus income taxes.
RMD: A SEP IRA has an RMD rule. You must start taking distributions from your account when you reach the age of 72.
SIMPLE IRA stands for Savings Incentive Match Plan for Employees, and is considered a budget version of a regular 401k plan. Any business owner with under 100 employees can open a SIMPLE IRA for their business. For example, if you have full-time employees, you’re not eligible for a solo 401k. You might decide to open a SEP IRA instead. However, because of the equal match contribution rules of a SEP IRA, it might get too expensive once you hire too many employees. In this case, a SIMPLE IRA may make the most sense.
Mainly for employees, not employers: The main benefit of a SIMPLE IRA for employers is that it offers them a cheaper, simpler alternative to offering a full 401k plan at their companies. If your goal as a business owner is to save as much as you can for your own retirement, a solo 401k or SEP IRA is the much better choice.
How it works: When employers set up a SIMPLE IRA, they get to choose between one of two ways to make contributions:
- Make non-elective contributions equal to 2% of an employee’s compensation, based on a maximum salary of $305,000 for 2022 and $330,000 for 2023.
- Make matching contributions up to 3% of an employee’s salary, not limited by any annual compensation limit.
If employers choose matching contributions, employees much contribute to their plans in order to receive the match. If employers choose non-elective contributions, employees receive contributions whether or not they make contributions on their own. All contributions are tax-deductible.
Contribution limits: The contribution limits of a SIMPLE IRA are smaller than a 401k or other retirement plans designed for business owners like the SEP IRA or solo 401k. You can contribute up $14,000 for 2022 and $15,500 for 2023. If you’re at least 50 years old, you can contribute up to $17,000 for 2022 and $19,000 for 2023.
Investment options: The investment options of a SIMPLE IRA are similar to the SEP IRA and traditional and Roth IRAs. You can invest in traditional assets like stocks, mutual funds, bonds, and ETFs.
Withdrawal rules: You must be at least 59½ years old in order to take qualified distributions without penalties. Any early withdrawals are subject to a 10% penalty plus income taxes.
Additional SIMPLE IRA withdrawal rule: A SIMPLE IRA has one additional withdrawal rule. If you make an early distribution within the first two years of participation, you’ll owe an extra 15% on top of the original penalty fees. For example, if it’s been less than two years since your first SIMPLE IRA contribution, and you want to take an early distribution before the age of 59½, you’ll owe a total of 25% in penalties to the IRS, plus income taxes. The two-year rule also applies to rollovers. You cannot rollover your SIMPLE IRA to another retirement account until two years has passed since your first contribution. Early rollovers will also receive the 25% penalty.
RMD: SIMPLE IRAs have required minimum distributions. You must start taking distributions from your account when you reach the age of 72.
There are many different types of retirement accounts, each one offering different tax benefits, contribution limits, withdrawal rules, and investment options. The most important distinction to understand with the different types of retirement accounts is the difference between traditional and Roth accounts. With traditional retirement accounts, you get a tax deduction up front, but your withdrawals in retirement are taxed as regular income. With Roth retirement accounts, you pay taxes on your income when you contribute, but withdrawals in retirement are tax-free.
The most common retirement plans are the corporate 401k plan and the traditional and Roth IRAs. While you can only contribute to a 401k if you work at a company that sponsors a plan, anyone with earned income can contribute to an IRA. However, people who make too high of an income cannot contribute to a Roth IRA.
Business owners and self-employed individuals have access to a solo 401k, SEP IRA, and SIMPLE IRA. A solo 401k offers the most tax benefits, but you can’t have any full-time employees. A SEP IRA does let you have employees, and works similarly to a solo 401k, but lacks a Roth options, catch-up contributions, or full checkbook control over your investments. A SIMPLE IRA is more for employees than employers, and can be considered a cheaper, simpler alternative to offering a 401k plan.