Retirement accounts come in a bewildering array of flavors. Employer-sponsored plans include 401(k), 403(b), 457 and profit-sharing plans, as well as the SIMPLE IRA and SEP IRA. On top of that, there are individual plans such as traditional and Roth IRAs, and also tax-deferred fixed and variable annuities.
How can you make sense of that mess? All of these accounts offer tax-deferred growth. That means you don’t have to pay taxes on any investment earnings until you draw down these accounts, typically in retirement. At that point, withdrawals are usually taxed as ordinary income, which could trigger a federal income tax rate as high as 39.6%. Sometimes, however, retirement accounts offer three additional benefits, as well as one big drawback.
First benefit: Some accounts offer an initial tax deduction. That’s the case with a tax-deductible IRA. Contributions to employer plans are often also effectively tax-deductible, because your contributions are taken out of pretax dollars.
Second, accounts such as the Roth 401(k) and Roth IRA won’t give you an immediate tax deduction, but they offer the chance not just for tax-deferred growth, but tax-free growth. You may even have a choice between, say, a tax-deductible 401(k) and Roth 401(k) or between a tax-deductible IRA and Roth IRA. You can, alas, never get both a tax deduction and tax-free growth.
Third, your employer’s retirement plan may include the chance to earn a matching contribution. Not contributing enough to earn the full employer match? That ranks as one of the most foolish financial mistakes.
Finally, there’s the big drawback: Some retirement accounts are inordinately expensive. That’s an issue with some employer-sponsored plans. But the biggest culprits are many, but not all, tax-deferred annuities.
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