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Retirement Plan: Definition & Types of Retirement Plans

What Is a retirement Plan?

A retirement plan is a tax-advantaged plan where you contribute money on a regular basis to save for retirement. In a retirement plan, the money grows tax free until you take it out. That is, interest and dividend income accumulates on a tax-deferred basis . Some types of retirement plans are Roth IRA, Traditional IRA, Simplified Employee Pension (aka SEP), 401k or 403b. Each of these plans that can help you save for retirement. 

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Retirement plans are important to have, because life expectancy today in the US is at least 75 years old. So, you will likely live many years in retirement. That also means that you will need money during those non-working years to live. You also can’t rely on government programs, such as Social Security. These programs may not exist in the future. That’s why you must have a retirement plan.

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Understanding Retirement Plans 

Plain and simple, a retirement plan is a plan that offers a way to save for retirement. In some retirement plans, the money comes out of your paycheck and get invested automatically. That is what is called an employer sponsored plan such as a 401k or a 403b. 

In that plan, your employer deducts a certain amount of money from your salary and invest it in high-return investments such as stocks. In these retirement plans, your money grows tax-free until you withdraw them at retirement.

However, you may have to pay a penalty if you take out some of the money if you need it for an emergency. Retirement plans are different than other investment accounts such as mutual funds investments because they are generally purchased with after-tax dollars. 

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Types of Retirement Plans

There are several types of retirement plans, which include Roth IRA, Traditional IRA, 401k, 403b, Simplified Employee Pension aka SEP, a Keogh Plan, etc. These retirement plans are all tax-advantaged plans. But they differ in some respects.

For example,  an IRA (Individual Retirement Account) is a form of retirement plan that you can create and fund yourself. Whereas, a 401k plan is a tax advantaged retirement plan created by your employer, in which you can contribute a certain amount from your salary.

401k – best overall retirement plan

One of the best retirement plans out there is the 401k. A 401k plan is a retirement savings plan that is offered by your for-profit company. If you work for a non-profit company, then you may have access to what’s called a 403(b) plan. Your contribution to a 401k plan is deductible on both federal and state taxes in the year you make them.

A 401k plan allows you to contribute up to $20,500 per year (for tax year of 2022). If you’re an older employee, at least age 50, you can contribute an additional $6,500 (called a catch-up contribution limit), making it a total of $26,000 each year.

In most cases, your employer may offer a match. That is if you contribute 3% of your paycheck, your employer may match it with 3%, making your 401k contribution 6%. Under some circumstances, you may be able to withdraw money from your 401k before age 59 1/2, but only if you show financial hardship. Otherwise, you’ll get hit with a 10% penalty and federal, state and local taxes on that amount. See more on the IRA vs 401k withdrawal rules below. 

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403(b) – retirement plan for non-profit employees

A 403b retirement plan is very similar to a 401k retirement plan. The main difference is that, this plan is offered by non-profit employers such as public schools, charities, public schools, etc, while 401k plans are offered by for profit employers. In a 403b plan, you contribute your money, which grows tax free until retirement.

IRA (Roth IRA or Traditional IRA)

Anyone who is earning an employment income (or receiving alimony) can open an IRA account. An IRA is also a retirement account that grows tax free until you withdraw the money. It is an individual account and not tied to your employer. Unlike a 401k, your yearly contribution to an IRA is much less.

You may contribute $6,000 into your IRA for the year of 2022. If you are 50 years old and older, you may contribute up to $7,000. Both wife and husband can contribute up to $6,000 each year, making it a total of $12,000 even if only one spouse is working. Your can deduct all of your traditional IRA contributions every year.

However, your IRA may not be deductible if you or your spouse participates in a retirement plan at work, like a 401k. If you cannot deduct your IRA contribution, consider opening a nondeductible account called a Roth IRA.

If you’re single with an adjusted gross income (AGI) of less than $124,000 or married filing jointly with an AGI of $196,000, you can contribute up to $6,000 per year to a Roth IRA. Those who are 50 years old and older can contribute $6,000.

The Keogh Retirement Plan

A Keogh retirement plan is available for those who are self employed, either part- time or full time. Self employed individuals who file  Schedule C may take advantage of this retirement plan.

A Keogh retirement plan has several benefits as well, just as an IRA or a 401k. One of the main benefits of having this type of plan is that even if you have a 401k plan, you can still have a Keogh to save that portion of your income that comes from being self-employed.

Another great advantage of a Keogh retirement plan is that you can contribute a higher maximum amount. The standard contribution for a Keogh plan is 25% of your self-employed income, up to $46,000. This is way higher than a 401k or IRA’s maximum contribution. 

SEP IRA Retirement Plan

Anyone who is self-employed, who is an independent contractor, or who has a small business with fewer than 25 employees can set up a SEP (Simplified Employee Pension) IRA. With this type of IRA plan, you can contribute 25% of your annual salary, or $61,000 for 2022, whichever is less.

The Bottom Line

A retirement plan is an effective way to save for retirement, mainly because of its tax advantages. Whether you are employed for a profit or a non-profit organization, you have many types of retirement plans to choose from. That can be a 401(k), a 403(b), a Roth IRA, a traditional IRA, or a SEP IRA. 

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