Types of Retirement Plans
Most retirement plans fall into one of two categories: self-directed or employer-sponsored. Each plan has its owns benefits and restrictions. The type of plan you choose depends on your employment status and income level. Self-employed individuals have different options than employees.
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Self-Directed Options
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The IRA and Roth IRA are the two most common self-directed retirement plan options. Traditional IRA (Individual Retirement Arrangement) contributions are tax deductible and grow tax deferred until withdrawal. Roth IRA contributions are not tax deductible, but they grow tax free and remain tax free on withdrawal. Contributions for both a Roth and a Traditional IRA are limited -- the caps were set at $5,000 for the tax year 2012 with $6,000 allowed for those 50 and over. Those who want to contribute to a Roth may face income restrictions, and the tax deductibility of Traditional IRAs may be affected if you or your spouse are covered by a retirement plan at work.
Old-School Employer Sponsored Plans
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During the 1950s and 1960s, most companies provided a fully-funded retirement income for their employees. Benefit amounts depended on years of service and income level. These were called Defined Benefit plans. However, the plans became cost prohibitive to the employers and were mostly phased out.
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Defined Contribution Plans
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The most common Defined Contribution plan is the 401(k). Employees with a 401(k) plan make a before-tax contribution with a partially matching contribution from the employer, if the employer decides to make one. All contributions and earnings are tax deferred until withdrawn, at which time withdrawals are taxed at standard income tax rates. Investment choices are usually a selection of diversified mutual funds. A 403(b) plan is the non-profit employee's equivalent of the 401(k).
Profit Sharing Plans
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Contributions are made completely at the discretion of the employer in a profit sharing plan, which allows the employer to contribute a share of the company's profits for the year to the employee's retirement plan. Such contributions are typically tax deferred, which means that no taxes are paid on the contributions or their investment growth until the money is withdrawn.
SIMPLE Plans
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A popular choice for the self-employed or smaller companies, SIMPLE plans are similar to 401(k) plans, but have higher contribution limits. The employer must contribute the same percentage to each employee: either 100 percent of employee deferrals up to 3 percent of compensation, or non-elective contributions up to 2 percent of compensation as of 2010.
457: Deferred Compensation Plans
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These plans are designed for those in the upper income bracket. By deferring income until retirement, the tax bracket will be lower theoretically, so fewer taxes will be paid on those earnings.
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