What Are Tax-Advantaged Retirement Accounts?

Starting early with tax-advantaged retirement accounts can make a significant difference in your retirement planning. Tax-advantaged retirement accounts are a favored vehicle for retirement savings, and understanding the various types available is the first step. Over half of Americans don’t know how a 401(k) works^[1]. Most of us pretend we do and nod along. At this point, many of us are afraid to ask.
To help you, we will review the different types of tax-advantaged retirement accounts without all the complicated financial jargon.

☝ This review should not be a basis for choosing a retirement account: that would take much more study. It’s a starting point that will help you get familiar with some of the most popular options

What Are Tax-Advantaged Retirement Accounts?

Tax-advantaged retirement accounts allow you to contribute a portion of your income to a retirement fund on a regular basis. You can then invest these funds to grow your retirement savings.

The term tax-advantaged does not mean that the money you contribute is not taxed. You will pay tax on your retirement income either when the funds are disbursed or when you make the contributions, depending on the type of account you have. Your investment gains over the life of the account are usually not taxed, as long as you use them after you retire. There are different types of rules and tax advantages attached to different types of accounts.

General Categories

There are many types of retirement accounts, but there are a few distinctions to understand before we start looking at specific types.

• 401(k) plans are usually offered through an employer. The employer selects the plan provider and sets the plan terms. Many employers match a portion of your contribution, which can be a significant benefit.
• Individual Retirement Accounts or IRAs are set up by the individual holding the account. You select the provider, which gives you more options.

There are also two general types of tax benefits.

• Traditional accounts allow you to deduct your contributions from your taxable income in the year you make them. You then pay taxes on the disbursements you receive in retirement. The money in these accounts has not yet been taxed, so the IRS has strict rules on how you can use it.
• Roth accounts allow you to pay tax on your contributions in the year that you make them. Your disbursements in retirement are tax-free. The money in a Roth account has already been taxed, so the rules on how you use it are generally less strict.

📘 Read all about the differences between Roth and traditional retirement accounts.

Each type of account has several variants, each with its own rules.

Key Features

Here are some features to look for while you assess different accounts.

• Eligibility. Some types of accounts are only available to people in certain categories.
• Income limits. People with incomes above a certain limit cannot contribute to some kinds of accounts.
• Contribution limits. There are usually limits to what you can contribute in one tax year.
• Withdrawal rules. Many accounts impose substantial penalties on withdrawals before you reach retirement age. There may be some exemptions to these rules, and you may be able to borrow from your account.
• Disbursement rules. You may be required to take disbursements from your account starting at a certain age.

The rules governing these accounts are detailed and extensive. We’ll give you a quick review, but you’ll need to do some serious research before making a final selection. If you’re not sure, consider consulting a professional advisor.

💡 The earlier you start saving for retirement, the more you can take advantage of these accounts’ earning potential. To maximize profits, start contributing as soon as you can.

Types of Tax-Advantaged Retirement Accounts

1. Traditional IRA

A traditional IRA (individual retirement account) is a tax-deferred retirement plan. The government won’t tax your contributions. You can deduct them from your taxable income in the year you make the contributions.

Once you retire, your disbursements from the account will be taxed as regular income. 

👍 Best for

• When you think your tax bracket will be lower in retirement.
• When contributing to it will put you in a lower tax bracket now.
• People who want flexibility. You can select your plan provider, and there’s a wide range of options and terms to choose from.

👎Disadvantages

• There are steep penalties for withdrawing money early.
• You must take Required Minimum Distributions starting at age 70 1/2.
• Limited annual contributions.

2. Roth IRA

A Roth IRA takes the opposite approach to taxes. You will pay tax on your contributions in the year you make them, but you can withdraw your funds tax-free after retirement. This makes them ideal for saving while you’re in a relatively low tax bracket.

👍 Best for

• When you think your tax bracket will be higher in retirement.
• When you may need to make early withdrawals. Roth IRA’s allow tax-free, penalty-free withdrawals of your contributions. 
• Reserve funds for late in retirement: Roth IRAs have no Required Minimum Distributions.
• Young savers in relatively low tax brackets.

👎 Disadvantages

• If your income is high you may not be eligible.
• Penalty-free withdrawals tempt you to spend your retirement funds
• Limited annual contributions.

3. SEP IRA

SEP stands for Simplified Employee Pension. A SEP IRA is taxed like a traditional IRA but offers higher yearly contribution limits (up to 25% of your salary). 

They’re easy and cheap to set up and employers can make contributions for themselves and their employees.

👍 Best for

• When you’re self-employed and considering having employees later on.
• Small business owners 
• When you want to make higher annual contributions than a traditional IRA.  

👎 Disadvantages

• Business owners have to set up SEP IRAs. If you’re an employee and your employer doesn’t offer one, you can’t get one.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

4. Spousal IRA

Typically, if you want to open an IRA you need to earn income. Luckily, there’s a loophole and it’s called a spousal IRA. If you’re married and your spouse is earning little or no income, you can open and contribute to a spousal IRA in his/her name. 

In terms of benefits and taxes, the spousal IRA is essentially just a traditional or Roth IRA. It’s a great way for a stay-at-home mom or dad to take advantage of a retirement plan, and for married couples to maximize their retirement savings.

👍 Best for

• Couples where one spouse earns little to no income.

5. SIMPLE IRA 

This IRA is another option for small businesses, offering significant benefits for employers and their employees. Your employer has to match your contributions or make non-elective contributions. These are yours right away and you can take them with you if you decide to leave the company. 

👍 Best for

• Small business owners.
• Self-employed individuals.
• When you want guaranteed employer matching contributions. 

👎 Disadvantages

• You can only have a SIMPLE IRA if your employer offers one or you are the employer.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

6. Self-Directed IRA

This unique type of IRA allows you to invest in more diversified portfolios. If you choose to go down this route, you will have more control over your investments. That can mean more profits, but it’s important to remember that it also comes with more risks^[2].

Self-directed IRAs offer a huge variety of investment instruments. You can invest in stocks, bonds, and mutual funds, but you can also experiment with real estate, precious metals, or even digital assets like cryptocurrency.  

👍 Best for

• When you have a more sophisticated understanding of investing.
• When you want more investment options and flexibility.

👎 Disadvantages

• Many of the available investment options expose you to higher levels of risk.

7. Non-Deductible IRA

If you don’t qualify to fully contribute to a traditional or Roth IRA, then a non-deductible IRA is a simple solution for you. While it doesn’t offer as many benefits as the other two options, whatever you invest in this plan does grow tax-free. 

Just remember you must proactively notify the IRS if you make contributions or you can run the risk of paying taxes twice.

👍 Best for

• When your income is too high to make tax-deferred contributions to a regular IRA.
• When you maxed out your contributions to an employer-sponsored retirement plan.

8. Traditional 401(k)

Named after a section in the IRS code, the traditional 401(k) is a tax-advantaged retirement account offered by your employer. What you contribute and earn is tax-deferred, similar to a traditional IRA. 

Some employers will match a portion of your 401(k) salary deductions, and you only pay taxes on your contributions and earnings when you retire and withdraw the funds. 

👍 Best for 

• When your tax bracket will be lower in retirement. 
• When contributing to it will put you in a lower tax bracket now
• If your employer’s 401(k) plan has advantageous terms.

👎 Disadvantages

• No choice of providers: your employer does that
• Some 401(k) plans have limited investment options and high management fees.
• Some employers impose vesting schedules: you can only get your matching contributions if you work for the company for a minimum period of time.
• Penalties for withdrawing money early.
• Required Minimum Distributions starting at age 70 1/2.

📘 If you don’t have access to a 401(k) or you don’t find the terms of your employer’s plan attractive, it might be worth looking into some 401(k) alternatives.

9. Roth 401(k)

Similar to a Roth IRA, this employer-sponsored retirement fund allows you to pay taxes on your contributions as you make them and withdraw your contributions tax free. The only funds that are not-tax exempt after retirement are your employer contributions. 

A Roth 401(k) doesn’t have the same income limits as a Roth IRA, meaning you can contribute to it even if you’re a high-earner. 

👍 Best for 

• Younger savers 
• When you think you will be in a higher tax bracket in retirement 

10. Solo 401(k)

If you’re self-employed but you still want the benefits of a 401(k), the solo 401(k) is your answer. It still follows the same rules as your typical 401(k) but it has other benefits that some traditional plans don’t offer.

Since you own the business, you can contribute as the owner AND the employee, which gives you a pretty hefty contribution room. You can even include your spouse in the mix under some conditions.

👍 Best for 

• Business owners with no employees 
• Self-employed individuals like freelancers and independent contractors etc.)

👎 Disadvantages

• Only a business owner and spouse can participate

11. SIMPLE 401(k)

Let’s call this a hybrid between your SIMPLE IRA and a traditional 401(k). You make tax-deferred contributions to it and your employer has to contribute to it too. 

If you’re a small business owner, this account is pretty hassle-free to set up, but your employees’ contribution limit is lower than that of a traditional 401(k). 

👍 Best for

• Small business owners 

👎 Disadvantages

• Must be offered by an employer
• Lower contribution limits than a regular 401(k)

12. Safe Harbor 401(k)

If you’re an employee under this plan, not only will your employer make contributions to it, but you have immediate ownership of the funds (or are fully vested if you want to get fancy). 

This account is popular with small business owners because it’s less costly to set up and you don’t have to pass the IRS annual nondiscrimination tests.  

👍 Best for

• Small business owners 

13. Profit Sharing Plan

As the name suggests, the company you work for shares its profits with you. This plan doesn’t give much control to you as an employee since the company decides how much they contribute or “share” .You also can’t make any contributions yourself as the company does it for you. 

Profit sharing plans can boost productivity and workplace satisfaction^[3]. Many employers offer them along with other types of retirement accounts. 

👍 Best for 

• Employees working for financially profitable organizations. 
• When you want another retirement plan to supplement your existing one. 

👎 Disadvantages

• Your employer decides whether to share profit or not. You have no say in the matter.

14. 403(b)

A 403(b) is a retirement plan for employees of non-profit organizations. The tax benefits and rules are similar to those of a traditional 401(k).

👍 Best for

• Employees of non-profit organizations.
• Some public-school employees.
• Church employees.
• Some ministers.

👎 Disadvantages

• Limited eligibility.

Consult With An Expert 

This review should give you a very basic understanding of tax-advantaged retirement accounts and the different types of available accounts. Remember that each one comes with more complex rules and requirements. It’s wise to consult with a qualified financial advisor or accountant before committing to a plan.