IRAs, 401(k)s and more: The alphabet soup of retirement investing


April is National Financial Literacy Month in the U.S. and also the deadline month for funding various types of retirement accounts.

Therefore, we thought it was a good time to take a quick tour through the array of retirement savings plans available to investors.

Individual Retirement Accounts

Traditional and Roth IRAs are established by individual taxpayers who contribute a portion of their pay. With a Roth IRA, there is no up-front tax break, but you don’t have to pay tax on withdrawals in retirement. The opposite is the case with traditional plans.

There are other important differences between the two as illustrated by this useful chart prepared by the IRS:

401(k) Plans

This is a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. Workers choose salary deferrals up to a set amount ($17,500 annually for traditional plans), which are excluded from the employee’s taxable income. That said, 401(k) plans come in many different flavors.

Some companies match employee contributions. However, since the financial crisis in 2008, employers have become less generous with company matches and have set lower limits for the maximum annual payment they’ll make to a 401(k) account.

Simplified Employee Pension Plan

This is basically a traditional IRA plan that is set up for employees by companies.  A business of any size, even self-employed, can establish a SEP.

Such plans are attractive to many companies, because they don’t have the high administrative costs of a conventional retirement plan. Workers can chip in up to 25% of their pay into these plans.

Profit-Share Plans

As the name implies, companies sometimes share their profits with employees in a separate account for each employee. Such contributions are discretionary and there is no set amount a company must make to qualify. There are contribution limits: The lesser of 25% of compensation or $51,000 (for 2013; $52,000 for 2014.

Defined-Benefit Plans

This is your grandfather’s corporate pension plan and increasingly a rarity these days. With a defined benefit pension plan, an employer uses payroll contributions and matching funds to guarantee a specified monthly benefit on retirement.

The amount is determined by a formula based on age, length of service and an employee’s earnings history rather than the fluctuations of investments backing the plan.

According to the Pension Benefit Guaranty Corporation, there are about 38,000 insured defined benefit plans today compared to a high of about 114,000 in 1985. Companies have moved away from defined plans due to their complexity and cost.

Employee Stock Ownership Plans (ESOPs)

Employee ownership plans come in several varieties. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit sharing plan. Some employees become owners through At worker cooperatives, where employees become owners, everyone has an equal vote.

But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan.  About 12,000 companies now have ESOPs or similar trust-based plans, covering over 11 million employees, according to the IRS.

Tomorrow is April 15! Check out our recent posts on last-minute tax tips and ideas for investing your tax refund.

You can also download our free investment guide on selecting retirement portfolios.

Photo credit: helium heels via Flickr Creative Commons.

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. Neither Covestor Limited nor its representatives are engaged in rendering tax, accounting or legal advice. A qualified professional should be consulted regarding the effect of such considerations on the matters covered in this article. Past performance is no guarantee of future results.