Types of Retirement Accounts

Saving money is essential for people's future financial security. Some saving, such as mandatory Social Security deductions from workers' wages, is required by law. Social Security contributions are stored in a general fund rather than in a personal account, however. Financial experts advise prudent saving and investing during people's working years to support their future financial security. Popular retirement accounts include the traditional individual retirement account (IRA), Keogh plan, Simplified Employee Pension (SEP) plan, and traditional 401(k) plan. All of these plans offer tax advantages, but none are federally insured.

A traditional IRA is a tax-deferred retirement account for employees. Taxes are not paid on the amount contributed to the traditional IRA, or on the interest that accrues, until the money is withdrawn during retirement. There are limits on the annual contribution to an IRA, and there are penalties for early withdrawal. In 2012 the maximum contribution for most people was $5,000 per year. Contributors can start withdrawing money from the IRA without penalty at age 59.5. The Employee Retirement Income Security Act (1974) created the first IRAs. A Roth IRA is a retirement account in which a worker contributes after-tax money to the account. The main benefit of a Roth IRA is that the principal, plus all interest earned during the life of the account, is tax free when withdrawn during retirement. Some upper-income people are not eligible to purchase Roth IRAs.[1] The Taxpayer Relief Act (1997) created the Roth IRA.

A Keogh plan is a retirement plan for the self-employed and small businesses. Income contributed to a Keogh plan is tax deferred until it is withdrawn from the account during retirement. Self-employed workers, often sole proprietors, can contribute up to 25 percent of their self-employment income to a Keogh plan as long as the sum does not exceed $49,000. In addition, employees of these small businesses can participate as long as the employer pays the entire contribution.[2] The Self-Employed Individuals Tax Retirement Act (1962) established the Keogh plan.

A Simplified Employee Pension (SEP) plan is another retirement plan for small businesses. SEP plans allow the employer to make tax-deductible retirement contributions directly into an individual retirement account (IRA) for each employee and are usually called SEP-IRAs. The amount of the contribution varies depending on the workers' wage and on market conditions—in good times the employer is free to contribute more money into the individual employee's SEP-IRA, and when business is slow the employer is free to cancel contributions completely. In 2012 the maximum contribution to a SEP-IRA was 25 percent of the worker's wage, with an upper limit of $50,000. SEP-IRAs have become more popular in recent years because they are easy to set up and offer employers some payment flexibility. SEPs were authorized by Congress in 1978.[3]

A traditional 401(k) plan is a retirement plan set up by an employer. Under 401(k) plans, the employer may match all or a portion of the employee's contribution to the retirement plan. The employee's contribution is tax deferred; thus, neither the contribution nor accrued interest payments are taxed until withdrawals are made during retirement. In 2011 the maximum annual employee contribution to a traditional 401(k) plan was $16,500 for employees under 50 years of age, and $22,000 for employees 50 or over—limits that were significantly higher than traditional IRAs or Roth IRAs. For sole proprietorships with no employees, the individual 401(k) plan offers even greater benefits because the proprietor is both employer and employee; hence, a larger contribution is possible each year. The risks involved in traditional 401(k) plans became painfully obvious in the early 2000s when the collapse of Enron and other large corporations wiped out several large 401(k) plans. The wave of business failures during the Great Recession of 2007–2009 also cut deeply into some traditional 401(k) accounts. The Internal Revenue Code of 1978, Section 401(k), created 401(k) plans.[4]

  • [1] IRS, Individual Retirement Arrangements (IRAs), Publication 590, December 16, 2011, 6–10;IRS, “Amount of Roth IRA Contributions That You Can Make for 2012,”; IRS, “IRS Contribution Limits,”; CNN Money, “Ultimate Guide to Retirement (IRAs),”
  • [2] CNN Money, “Ultimate Guide to Retirement (Keogh Plan),”
  • [3] IRS, Retirement Plans for Small Business, Publication 560 (for use in preparing 2011 returns), February 7, 2012, 2-3, 5; IRS, “Chapter 15: Simplified Employee Pensions (SEPS),” prepared by George Drosehn and Al Reich; Department of Labor (DOL), “SEP Retirement Plans for Small Businesses,”
  • [4] IRS, “401(k) Resource Guide: Plan Sponsors, 401(k) Plan Overview,”; IRS, “401(k) Plans,”; Stuart Robertson, “The Top Three Retirement Plans for Small Business,” Forbes, March 29, 2011; CNN Money, “Ultimate Guide to Retirement (401(k) plans,”
 
< Prev   CONTENTS   Next >