Most people who have had a job either have, had, or have access to some type of retirement account. However, few people understand how to decipher the different options available to them. While it can seem a daunting task, understanding your retirement options is one of the important steps in building a strong foundation for your personal financial life.

So, what’s a retirement account and what makes it so special from any other type of account?

The biggest difference between retirement accounts and any other type of saving you might do comes down to taxes. Every retirement account comes with some type of added tax benefit which can make a big impact on your savings toward retirement.

Tax benefits and retirement all sounds fairly boring, do I really need to worry about this now (or this year, or decade)?

Actually, yes! Retirement saving sounds stodgy but is really just saving with a specific goal. As with all types of savings, the sooner you begin the bigger impact it will have on your overall success, thanks to compounding interest. So, while it doesn’t sound like the most exciting activity in the world it is one that’s great to do for your future self. Trust me, your future self agrees.

Ok, so if you’re still reading at this point we’ll assume that you weren’t scared away by the title or subject matter so far and are actually interested in retiring at some point. Let’s consider some of the different types of retirement accounts you might come across and some of the advantages and disadvantages of each.

Retirement accounts can be generally divided into two categories: a company or personal. A company retirement account is one you’ll have through your employer and you’ll typically get a new one for each company you work for. A personal retirement account is one you set-up for yourself and can use no matter what company you work for.

Company Retirement Accounts

401k

This is by far the most common type of retirement account people come across as it’s the type of plan you’re likely to see if you work at a for-profit company with more than just a few employees.

Pros:

  • Your employer might match some or all of what you put in, check with them!
  • You don’t pay income taxes on the money you put into your account, yet.
  • The money you deposit comes straight out of your check, it takes little effort
  • Your employer may offer a Roth 401k option with the similar tax benefits as Roth IRA below

 

Cons:

  • You’ll pay tax when you withdraw money in retirement
  • You’ll pay an additional penalty for any withdraws before age 59 ½
  • You may not be able to make a withdraw while employed at the same company, barring a few exceptions.
  • Your employer may only match a portion of what you want to save
  • Your investment options may be limited, with high fees, do some homework

 

403b

This type of retirement account is essentially similar to the 401k, the main difference is it’s offered when you work for a non-profit. The pros and cons under 401k would mostly apply.

 

457

This type of retirement account is essentially the same as a 401k or 403b, the main difference is it’s offered when you work for a government employer. The pros and cons under 401k would mostly apply.

 

Simple IRA

This type of account is similar to a 401k but offered through a small business. In a Simple IRA, you may have much more investment options depending on who your employer uses to manage the accounts. Typically, an employer will match whatever you put in up to 3%, the max they’re allowed to. Many of the pros and cons of a 401k would apply as well.

 

SEP-IRA

These accounts are somewhat rare and typically offered by a small business with few employees. They have much of the same pros and cons of a 401k but the employer contributes a certain percentage of the profits to each employee’s account rather than a matching system. You likely won’t encounter this account unless you work for a very small business.

 

Personal Retirement Accounts

IRA

An IRA is, in many ways, like a 401k you choose to set-up for yourself. The benefit here is that you can invest it in almost any way you choose and you can typically find an investment manager to help you with it as well. IRAs (or Traditional IRAs) operate like a 401k in that the money you put into them isn’t taxed until you decide to withdraw it during retirement.

Pros:

  • You choose how much to put in, up to the annual limit set by the IRS
  • You get a tax deduction on anything to put into your account.
  • You can invest in almost anything you want and choose any broker you wish

 

Cons:

  • You’ll pay tax when you withdraw money in retirement
  • The IRS sets an annual limit on how much you can contribute
  • You’ll pay income taxes PLUS a 10% penalty on any withdraws before you are 59 ½
  • The IRS will require you to start making withdrawals when you turn 70

 

Roth IRA

A Roth IRA is similar in most ways to an IRA but is taxed completely opposite. Instead of paying taxes during retirement you’ll pay your normal income tax now on anything you put into your account. However, you’ll never pay tax on any withdrawals during retirement (unless Congress changes any rules by then). There are a few other pros and cons as well.

Pros:

  • You choose how much to put in, up to the annual limit set by the IRS
  • You don’t pay taxes anything you withdraw from the account in retirement
  • You can invest in almost anything you want and choose any broker you wish
  • You may withdraw up to what you’ve contributed to the account tax and penalty free (after the account is open 5 years), just not the earnings

 

Cons:

  • You’ll pay your normal income tax on anything you put in the account
  • The IRS sets an annual limit on how much you can contribute
  • You’ll pay income taxes PLUS a 10% penalty on any withdrawals greater than what you have contributed if you do it before you are 59 ½, with a few exceptions.

 

Inherited IRA (or Roth IRA)

This is essentially the same as a normal IRA or Roth IRA except you would have inherited it from someone who’s passed away. Generally, the same tax rules for either the IRA or Roth IRA will apply except you won’t be penalized if you withdraw any before you’re 59 ½.