Having a retirement plan in place is vital for helping you to enjoy your retirement by providing you with additional funds to live on. But just which type of retirement plan should you choose? There are a few popular options available in the US. This guide aims to explain the difference between four of the most popular retirement plan options: traditional IRAs, Roth IRAs, 401(k)s and annuities. 

Traditional IRA

A traditional IRA (individual retirement account) is one of the simplest options. It is a savings account which you regularly contribute part of your salary into. You do not have to pay income tax on money contributed into your IRA. This makes it a great way to lower your taxable income while saving up a pension pot. 

Unfortunately, when you do eventually withdraw the money, you do then have to pay tax on it.

Pros:

  • Lowers your current taxable income.
  • A variety of options when it comes to where you want to invest your savings

Cons:

  • You have to pay tax on withdrawals in retirement.
  • You must start withdrawing money at the age of 73 – otherwise there will be penalties. 

Roth IRA

A Roth IRA is another form of individual retirement account that works slightly differently to a traditional IRA. Instead of contributing earnings before tax, you contribute earnings after tax. This means that you are not making any savings in income tax. 

The upside is that you don’t have to pay tax when you withdraw these savings in retirement. So whereas a traditional IRA allows you to save money on tax now, a Roth IRA allows you to save money on tax later during retirement. 

Pros:

  • You don’t have to pay any tax on withdrawals.
  • A similar variety of investment options to choose from.

Cons:

  • You contribute money after tax – so you don’t get an immediate tax break.
  • Those on a high income may be ineligible to make Roth IRA contributions.

401(k)

A 401(k) is similar to a traditional IRA, however your employer helps to sponsor it. You pay contributions into it pre-tax like a traditional IRA. Your employer then agrees to match what you contribute into it – essentially doubling your retirement fund. 

Although a 401(k) can result in an immediate tax break, you will have to pay tax when you eventually withdraw your savings in retirement – much like a traditional IRA.

Pros:

  • A 401(k) typically has higher contribution limits than IRAs – making it more suitable for those on a higher income.
  • Your employer matches your contributions – allowing you to save up more funds without having to contribute it all from your own earnings. 

Cons:

  • Options as to where you invest your savings are limited compared to IRAs.
  • Withdrawals are taxed like a traditional IRA – and you may face further fees if you try to withdraw early.

Annuity

It is possible that if you live long enough, you may spend all of your retirement savings before you die. Buying an annuity is a way of guaranteeing a regular income for the rest of your life. This involves trading in your savings (which could be from a traditional IRA, Roth IRA or 401(k)) for an insurance product that will pay you a regular income (either monthly, quarterly, semi-annually or annually depending on what you would prefer). 

The amount of savings you put into an annuity will determine how much you are paid regularly. If you’re only able to contribute a small amount of savings, your annuity payments will be quite small. If you’re able to contribute a large pension pot, your annuity payments could be quite large. The state of your health also determines how high these payments are – if you are already in poor health, your annuity payments will be larger. 

Pros:

  • Instead of having to live on a finite pension pot, you are guaranteed an income for the rest of your life. 
  • An annuity could make it much easier to budget your finances.

Cons:

  • Once your savings are converted into an annuity you may not be able to get them back.
  • Annuities can come with additional fees and may be liable to tax (depending on the annuity you choose), which could reduce the amount of money you receive.

Conclusion

The best type of retirement plan for you may depend on your income, your retirement goals and whether you want to save money on tax now or later. It is worth noting that these are not the only form of retirement plan and that there are other unique options for those who are self-employed or working in certain trades. Talking to a retirement advisor could help you to determine the best retirement plan option for you.