The road to retirement is different for everyone. Workers have many paths to help save for retirement as they travel toward the same goal. Since retirement funds are an important part of many estate plans, you should understand the most common types of retirement accounts. Read on to learn more about these accounts and their various tax implications.

Important Aspects of Retirement Accounts

The laws regarding retirement accounts provide workers with several favorable options to grow their nest eggs. The most important aspect of these options is tax deferral, which is available whether the funds are taxed before they are contributed or when they are withdrawn. However, the government has safeguards in place to make sure that funds are used for retirement and not just allowed to grow indefinitely without being taxed.

To that end, retirement funds must be withdrawn by the required beginning date (RBD), which is April 1 in the year after the retiree’s seventy-second birthday. The required minimum distribution (RMD) is calculated based on the value of the retirement account and the retiree’s life expectancy.

Retirement accounts have limits even before retirement, as a 10 percent penalty applies to many early withdrawals. With these basic rules in mind, here are five of the most common types of retirement accounts.

1. Traditional Individual Retirement Accounts

An individual employee (or nonemployee worker) can set up a traditional individual retirement account (IRA). If an employer does not offer a retirement plan, contributions to this account can be partially or fully tax deductible, depending on the worker’s income and filing status. If contributions are fully deductible, income taxes do not apply until the worker withdraws the funds.  

2. Roth IRAs

Named after Delaware Senator William Roth, this version of the IRA became available in 1998. It is significantly different from a traditional IRA in that the taxes are assessed up front; however, after retirement, the worker can receive tax-free distributions. In addition, since the government has already taken its cut, the early-withdrawal penalties and RMDs do not apply. Workers under the age of fifty can contribute $6,000 per year to a Roth IRA, while those older than fifty can put away $7,000 per year. However, Roth IRAs are not available to high-earners.

Learn more about retirement accounts and earn 7 CLE credits by watching WealthCounsel’s Retirement Planning Workshop with retirement planning expert, Natalie Choate. Now available on-demand until June 30, 2022.

3. ERISA-Qualified Plans

ERISA-qualified retirement plans were established under the Employee Retirement Income Security Act (ERISA) of 1974. Any plans that meet the requirements of ERISA section 401(a) fall into this category. These plans have more income tax incentives than nonqualified plans. ERISA-qualified plans fall into two categories: defined benefit plans and defined contribution plans. 

Your grandfather’s pension plan is likely an example of a defined benefit plan. These plans have become less common over the years.

Defined contribution plans allow the employee to voluntarily contribute to an individual account. The employer may contribute as well. The following are some examples of defined contribution plans:

• 401(k) accounts
• Other cash or deferred arrangement (CODA) accounts
• Profit-sharing plans
• Money-purchase pension plans 
• Stock bonus plans
• Target benefit plans
• Employee stock ownership plans (ESOPs)

4. Nonqualified Plans

Employer-sponsored plans that do not qualify under ERISA section 401(a) fall into the category of nonqualified plans. These plans are usually held by highly compensated workers.

5. SEP and SIMPLE Plans

Instead of sponsoring a retirement plan, employers will sometimes make direct contributions to their employees’ IRAs. This arrangement is called a simplified employee pension (SEP) plan. These may still exist, although they were phased out in the mid-1990s in favor of the Savings Incentive Match Plan for Employees (SIMPLE)—an alternative to a 401(k) plan that is more common among smaller employers. 

Learn More About Retirement Accounts

Now that you know the basics about the most common types of retirement accounts, you can expand your knowledge by watching WealthCounsel’s Retirement Planning Workshop with retirement planning expert, Natalie Choate. Now available on-demand until June 30, 2022.