The Complete Guide to Retirement Account Types

with No Comments

There are so many different IRS-recognized retirement account types. Knowing the differences between them can be very valuable but also very difficult to acquire.

Here is a simple list of many of the retirement account types and their differences. That being said, if you are making a tax decision for the year, don’t rely on this article alone. Read the IRS documentation pertaining to your specific account type or talk to your tax preparer.

Also, on their website, the IRS has what they call the “Rollover Chart.” You can see the latest one on the IRS Website here and a saved copy of today’s IRS Rollover Chart here. It details for each account if you can move assets from one account type to another account type. This can be helpful if you are trying to move assets into a more advantageous account type.

Retirement Accounts in General

In general, all retirement accounts have annual contribution limits. Those limits vary based on the type of account. If you contribute more than the contribution limit, you are both issued a penalty tax and required to reverse the contribution.

Some contributions are able to be deducted on your tax return, others are excluded or deferred from your wages so they are not included in your W-2, and other still are made as post-tax or nondeductible contributions.

Another common trait of retirement accounts is that you are only allowed to withdraw “qualified distributions” without a penalty. Any non-qualified distributions face a penalty tax (normally 10%). In general, retirement distributions are qualified distributions if you are older than age 59 1/2. However, different account types have additional qualified distribution conditions.

Pre-Tax Individual Retirement Accounts

This category of IRA is one where the contributions go in pre-tax. Contributions are, in general, either excluded or deducted from income, though nondeductible contributions are allowed and the burden is on the tax payer to track the basis nondeductible contributions.

All pre-tax IRAs are all subject to Required Minimum Distribution rules, and distributions are taxed as income (excepting any nondeductible portion). Individuals over age 70 1/2 can also give Qualified Charitable Distributions (QCDs) from any type of IRA account — traditional, rollover, inherited — excepting only “ongoing” SEP or SIMPLE IRAs.

IRA contribution limits cap the amount you can contribute in one year. If you contribute and are below certain adjusted gross income (AGI) limits, you can take an IRA contribution deduction. Otherwise, you can only make nondeductible contributions.

At any age and for any reason, you can convert any non-inherited IRA to a Roth IRA via a Roth conversion. When you do this, the amount you move from a pre-tax IRA to a Roth IRA is included on your tax return for that year as taxable income.

Traditional IRA or Contributory IRA

These are two titles for the same type of account. This is the standard type of pre-tax IRA. It has all the above standard rules and no extras.

Rollover IRA

Rollover IRAs are treated as identical to traditional IRAs by the IRS. The difference is that the money in a rollover IRA came out of an employer-sponsored plan.

Assuming your current employer-sponsored plan allows roll-ins, money which was rolled out of an employer-sponsored plan is capable of being transferred back into an employer-sponsored plan. The Rollover IRA account type is just a way of keeping track of which money has this special treatment.

Alas, if you ever contribute to an IRA Rollover for any reason such as normal IRA funding, Roth conversion, or consolidating two IRAs together, the Rollover IRA becomes a normal traditional IRA and you may lose the option of rolling it into an employer plan in the future. Thus, you should keep your rolled over employer plan assets separate from your traditional IRA or backdoor Roth assets.

Employer-sponsored retirement plans can be unruly for investors. The investment options may be overly limited, and the rebalancing options may be frustrating. The fund options may have higher than normal fees. If you have spent your career with multiple firms, you may have multiple small retirement plans spread out across a wide range of custodians. For this reason, many people transfer their money out of their employer retirement plans after leaving employment at the firm.

If you are moving money out of the pre-tax side of a employer retirement plan, then you can roll the money into a Rollover IRA. By default, you should always roll your employer assets into a rollover account instead of a contributory account because you never know what you’ll want to do with those assets later.

For example, you only get the full benefit of a backdoor Roth when you have no other traditional IRA assets. Because employer plans do not count as IRA assets, if you are looking to do a backdoor Roth, you may want to roll your IRA Rollover back into an employer plan if your income is above the Roth contribution modified adjusted income (MAGI) line.

Custodial IRA

A custodial IRA is simply a traditional IRA which is owned by a minor and managed by a custodian (like a guardian, except for a minor’s assets). These IRAs remain custodial accounts until the minor reaches the age of majority, which is typically 18. At that point, they become regular traditional IRAs. They have the same rules as the standard pre-tax IRA.

Inherited IRA

An inherited IRA holds pre-tax assets where the original owner is now deceased. Inherited IRAs, unlike all other kinds of IRAs, do not allow contributions.

Their required minimum distributions are subject to an entirely different set of rules, explained here “How You Take Your Inherited IRA RMD Is the Exception to the Rule.”

You cannot rollover an inherited IRA into any other type of account, and you also cannot convert an inherited IRA to a Roth.

All you can do with it is take distributions, either your required minimum distributions or more than that.

Post-Tax Roth Individual Retirement Accounts

This category of IRA is one where, in general, the contributions are made post-tax. Contributions are tax neutral. There is no tax deduction. There is no deferred or excluded amount. They do not decrease your taxable income at all.

Roth IRAs then have the benefit that all qualified distributions are not taxed as income. Also, all non-inherited Roth accounts are not subject to required minimum distributions.

IRA contribution limits cap the amount you can contribute in one year. This limit is shared with traditional IRAs. If you are over certain AGI limits, you are no longer allowed to contribute to a Roth IRA. Instead, you perform a backdoor Roth by making a nondeductible contribution to a traditional IRA and then converting this amount to Roth. Keep in mind you only get the full benefit of a backdoor Roth when you have no other traditional IRA assets.

Roth IRA or Contributory Roth IRA

These are two titles for the same type of account. This is the standard, plain-vanilla type of post-tax IRA. It has all the standard rules and no extras.

Custodial Roth IRA

A custodial IRA is simply a Roth IRA which is owned by a minor and managed by a custodian (like a guardian, except for a minor’s assets). These IRAs remain custodial accounts until the minor reaches the age of majority, which is typically 18. At that point, they become regular Roth IRAs. They have the same rules as the standard Roth IRA.

Roth Conversion IRA

This is an IRA where the source of the assets are from a traditional IRA and rolled over to Roth via a Roth conversion. Roth Conversion IRAs are treated as identical to Roth IRAs by the IRS. And now, after 2018’s repeal of Roth recharacterizations, they are identical account types.

Inherited Roth IRA

An inherited IRA holds post-tax assets where the original owner is now deceased. Inherited Roth IRAs, like inherited traditional IRAs, do not allow contributions.

Inherited Roth IRAs are also subject to inherited RMD rules. Luckily, these Roth RMDs are still post-tax distributions and thus not taxed.

You cannot rollover an inherited Roth IRA into any other type of account. All you can do with an inherited IRA is take distributions, either your required minimum distributions or more than that.

Employer Sponsored Retirement Accounts

401(k) plan

401(k) plans are retirement accounts offered by your employer. They are governed by their own plan contracts, which means that the specific rules vary from plan to plan.

Contributions utilize the Employee Elective Deferral contribution limit, which is higher than the regular IRA limits. Depending on the plan options, you may be able to contribute either to a traditional pre-tax side of the plan or a post-tax Roth side of the plan. These are called “employee deferrals” and “employee Roth deferrals” respectively.

The plan may also include an employer match or a profit-sharing portion into which your employer can contribute additional pre-tax assets.

401(k) plans are subject to Required Minimum Distribution (RMD) rules, but you must be older than the RMD required beginning date and either have terminated employment with the sponsoring employer or are more than a 5% owner of the company to be required to begin those distributions.

Anyone who has to take RMDs from their employer sponsored retirement plan, sadly, has to take RMDs from all components of the plan. This includes traditional employee deferrals, profit sharing, employer match, and even Roth deferrals! For this reason, we recommend that you rollover your Roth assets to a Roth IRA as soon as you can so that you have no chance of those assets being subject to RMD rules.

401(k) plans can be rolled over into Rollover IRAs for the pre-tax side or Roth IRAs for the post-tax side. This can normally only be done when the employee is “out of service,” meaning terminated, retired, or over age 59 1/2. While “in service” with the employer, you may only have access to a limited portion of the funds in the plan.

403(b) plan or Tax-Sheltered Annuity or TSA plan

A 403(b) plan is basically identical as a 401(k) plan except that 403(b) plans can only be offered by public schools and certain 501(c)(3) tax-exempt organizations.

403(b) plans use the Employee Elective Deferral contribution limit, and share this limit with 401(k) plans, except that they also allow for extra contributions for employees with over 15 years of service with the employer.

457(b) plan or Deferred Compensation Plan

457(b) plans are only available for certain state and local governments and tax-exempt non-governmental entities under IRC Section 501. Whether the plan is governmental or not determines some of the allowed features.

For example, 457(b) contributions can be either post-tax Roth or pre-tax traditional if the plan is government sponsored, but the contributions can only be pre-tax traditional if the sponsor is merely a tax-exempt charity.

457(b) plans use their own Employee Deferred Compensation contribution limit; it just happens to be the same numbers as the 401(k) and 403(b) plans. Depending on the plan document, they also may allow special 457(b) catch-up contributions equal to double the contribution limit when you are 3 years prior to the plan’s specified retirement age.

Like other employer plans, 457(b) plans are subject to Required Minimum Distribution rules.

Unlike other employer plans, 457(b) plans allow for “Unforseeable Emergency Distributions.”

Simplified Employee Pension IRA or SEP IRA

SEP IRAs are another type of employer sponsored plan. Unlike other plans, they cannot have a post-tax Roth option, all contributions must be pre-tax traditional.

Also unlike other plans, the assets are immediately accessible by the account owner; they do not have to wait until they are “out of service” (retired or terminated) in order to access them. This means the balance of a SEP IRA could be converted to a Roth IRA in the same year your employer contributed to it.

Unlike 401(k) plans, which are laden with record keeping and other fees as well as having limited investment and rebalancing options, SEP IRAs can be hosted by any custodian permitted by your employer, do not have limited investment options, and can be traded in per usual.

Also unlike other plans, SEP IRAs are available to self-employed workers or contractors.

Only an employer can contribute to a SEP IRA. Their contributions are subject to the Employer Contribution limit. This limit is applied separately for each employer, although “related employers” share the same limit.

Like other IRAs, SEP IRAs are subject to Required Minimum Distribution rules.

SIMPLE IRA or Savings Incentive Match Plans for Employees

SIMPLE IRAs have the smallest contribution limits of the employer sponsored retirement accounts, which is what makes them different. They are also the easiest to establish as there is a pre-made government form you simply fill out to establish a plan.

Like SEP IRAs, the assets are immediately accessible by the account owner; they do not have to wait until they are “out of service” (retired or terminated) in order to access them. This means the balance of a SIMPLE IRA could be converted to a Roth IRA in the same year your employer contributed to it.

Like other IRAs, SIMPLE IRAs are subject to Required Minimum Distribution rules after age 70 1/2.


Conclusion

With each of these types of retirement accounts, it can be confusing to determine where to save money for retirement. Which account you should fund depends on your circumstances. However, here are some general guidelines you can follow to make your decision. Keep progressing through each level by either contributing the maximum contribution limit or the described amount until you have saved everything you were going to save.

First, fund your 401(k) or 403(b) enough to receive any employer match. Funding your employer account sufficiently to get the employer match could be an immediate 80% return on your investment. Don’t miss out! Select the Roth side of your plan if available. If not, fund the traditional.

Next, fund your Roth IRA. For the average individual, contributing to a Roth IRA is better than a traditional IRA. Also, funding your Roth is a great idea even if you are just using it as a tax-free savings account or if you are effectively converting taxable savings to your Roth.

If you can’t fund your Roth directly, contribute using a backdoor Roth. There are only a few reasons you may not want to do a backdoor Roth.

Then, fund any other Roth options. This could be 401(k), 403(b), or 457 plans. Fund them to the maximum if possible

Next, contribute to your SEP IRA. A SEP IRA is also a good vehicle for professors who consult or lecture, doctors who engage in expert testimony, or other professionals who have incorporated a portion of their work. They can contribute an employer contribution to their own SEP IRA while their unrelated main employer is also contributing more to their 403(b) plan. Consider converting it to a Roth immediately.

Next, max out any retirement accounts not yet maximized. For example, if your 401(k) is only traditional, you could consider deferring up to the maximum deferral amount at this stage.

Lastly, save in your brokerage account. Saving money in a taxable investment account is always a good default. It biases you more towards investing your savings than if you were to put it in a checking account. This bias towards investing then helps to overcome some of the effects of inflation.

Photo by Sharon McCutcheon on Unsplash

Follow Megan Russell:

Chief Operating Officer

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine