How Do Retirement Savings Accounts Work?

While monthly payments from Social Security can help with covering costs during retirement, you'll often need additional funds to have the standard of living you'd like to enjoy. Retirement savings accounts help you build your savings for those years and come in several versions that may be offered through an employer or opened on your own through a financial institution. Depending on the type of retirement plan you choose, you might get benefits like employer contributions that may match your employee contributions along with tax breaks and tax deductions that provide benefits beyond the potential gains on your savings.

Here's what to know about how the different types of retirement savings accounts work and what to think about when choosing an account, learning what may be tax-deductible, deciding on your contributions and withdrawing funds.

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An individual retirement account (IRA) is a popular choice for saving for retirement through a financial institution. Your account can hold a variety of low- and high-risk investment choices such as mutual funds, index funds, certificates of deposit, stocks, money market funds and exchange-traded funds. Two popular options include traditional and Roth IRAs, and as of 2021, you get to put up to ​$6,000​ a year in such an account (​$7,000​ for those 50+) to be within the IRA contribution limits. These two accounts offer different tax benefits and rules for eligibility and withdrawals.

A traditional IRA is tax-deferred on the money contributed until you make withdrawals later and is available to anybody making income through employment. So, this kind of retirement plan can appeal to people who earn a lot now and want to postpone the tax bill until they're lower-earners in a lower tax bracket during retirement. When you make withdrawals after you turn 59 1/2, you'll need to pay taxes on the money at your current tax rate, and mandatory minimum withdrawals apply once you're ​72​.

On the other hand, a Roth IRA allows for tax-free withdrawals since you'll use after-tax dollars, but you'll need to have the account for ​five years​ to benefit from interest-free earnings. Further, you can face ineligibility or a smaller annual contribution limit if you earn more than ​$125,000​ when single or ​$198,000​ when married filing jointly. Roth IRAs appeal to people who don't want to worry about paying taxes on the money after retirement. You don't have to worry about required minimum distributions with this type of IRA.

​Read More​: What Does Roth Stand for in Roth IRA?

While Roth and traditional IRAs remain the most popular IRA options, you can find a few others that may appeal to you if you work for or run a small business.

For example, it may be that a small business employer offers a simplified employee pension SEP IRA option where you'd have a traditional IRA that they'd contribute to, but you don't have contributions taken directly from your paycheck. This account has a higher 2021 annual contribution limit of ​$58,000​ or ​25 percent​ of your salary, whichever is smaller. You can only get this account if you're ​at least 21​ and meet specific earnings and employment requirements such as having recently worked ​at least three years​ for your employer and making ​$600​ or more.

There's also the Savings Incentive Match Plan for Employees (SIMPLE) IRA that has a ​$19,500​ contribution limit for 2021, allows for ​$3,000​ catch-up contributions for people 50+ and usually provides a ​2 to 3 percent​ employer-matched contribution, often known as free money. A SIMPLE IRA has a minimum income requirement of ​$5,000​ to qualify, and you must have earned that much in the ​last two years​ and expect to do so in the current year too.

As an alternative to IRAs, you can find traditional and Roth 401(k) accounts that an employer will sponsor, so you don't open this account directly through a financial institution. Usually, these accounts will feature a lot of mutual funds, but annuities, bonds, stocks and other investments are also possible.

With these accounts, you'd set aside a certain amount of money to come from your paycheck, and your employer often provides some match for your contributions where a vesting schedule applies. You can have as much as ​$19,500​ (​$26,000​ if you're 50+) put into a 401(k) in 2021.

Traditional and Roth 401(k) accounts have similar tax differences as their IRA counterparts. As with a traditional IRA, a traditional 401(k) involves pre-tax contributions, so you'll deduct those from your taxable income now and pay taxes upon withdrawal. A Roth 401(k) uses after-tax dollars, so this means you can withdraw earnings tax-free during retirement, but unlike with a Roth IRA, you won't have to deal with income limits to contribute to a Roth 401(k). Both varieties of 401(k) accounts have mandatory minimum distributions for retirees ​after age 72​.

Alongside the most popular traditional and Roth 401(k) accounts exist various other options such as the following:

• ​Solo 401(k)​: Coming with the same contribution limit as traditional and Roth 401(k)s, this option allows a self-employed person without employees to contribute a higher amount of money than they could with an IRA. However, it doesn't offer the potential for matching like those working for an employer. You can choose from Roth and traditional options and receive the related benefits. You get this kind of account through an online broker.

• ​SIMPLE 401(k)​: Like a SIMPLE IRA, a SIMPLE 401(k) has the same ​$13,500​ contribution limit (​$16,500​ for those 50+) and is for small employers. Employees contribute pre-tax dollars from their paychecks, and the plan has most of the same rules as SIMPLE IRAs except that there's an employee compensation cap of ​$290,000​.

• ​Safe Harbor 401(k)​: While most 401(k) accounts with employer contributions have vesting rules where the employee will own those contributions on a certain schedule, the Safe Harbor 401(k) involves immediate vesting of such funds. This appeals to businesses who want to worry less about the nondiscrimination test the IRS requires that ensures all employees get fair employer contributions. This plan comes with various matching options and has the same contribution limits as traditional and Roth 401(k)s.
  

If your employer is the government or a non-profit organization, you might come across 403(b) and 457(b) plans as an alternative to the 401(k) options discussed. Both accounts have the same 2021 contribution limit as 401(k)s. Some organizations will allow you to get both these plans and split your contributions.

Featuring penalty-free early withdrawals, a 457(b) is most often available to government employees. Such plans tend to offer matching benefits less often, but they do come with the benefit of being able to contribute beyond the usual limits if you'll reach retirement age ​within three years​.

A 403(b) plan, on the other hand, is for people who work for types of tax-exempt organizations such as schools and churches. You may get to choose from traditional and Roth options that affect the tax benefits. The investments in such plans usually include mutual funds and annuities.

​Read More​: Retirement Plans for Employees of Non-Profits

When exploring all these retirement plan options you have, you'll want to consider eligibility at first to narrow down which investment options you have. For example, if you work for a for-profit employer, your work might offer traditional and Roth 401(k) options, while you might have a special 401(k) if you're working for a government or non-profit employer. Solo business owners would need to consider more limited options like a Solo 401(k). You can consider Roth and traditional 401(k) options regardless of the type of employee status you have.

After narrowing down the options applying to you, consider potential tax benefits and preferences for accessing the money. If you earn a lot now, traditional 401(k) and IRA options may help by deferring those taxes, while low earners might opt for Roth accounts to deal with less tax money due later. Keep in mind that most of the retirement savings accounts will penalize you with a ​10 percent​ fee (​25 percent​ for a SIMPLE IRA within ​two years​ of opening the account) if you need the money before age 59 1/2. This is in addition to any taxes you owe, so consider the likelihood of an early withdrawal and the financial consequences of your choice.

You have the option to take advantage of multiple retirement account options you qualify for too. However, keep in mind that opening two IRAs or 401(k)s won't cause the annual contribution limits to double. Further, having both a 401(k) and a traditional IRA can cause you to lose the ability to deduct your IRA contributions from that year's income.

While your choice of retirement account will determine the maximum amount you can contribute yearly, you'll want to know how much you'll need through your retirement planning to set aside the right amount of money. You can use general rules of thumb such as setting aside ​10 to 12 times​ what you make now or aiming to save enough to have at least ​60 percent​ of your current income for each year after retirement.

To get a clearer estimate, you can consider your expected Social Security payment plus any money you might get through side work during retirement first and get a rough annual income. You can then think about your expected expenses including bills and costs for leisure activities to get a yearly expenses number. You'll need to then have enough money to withdraw from a retirement savings plan to cover that gap.

A retirement calculator can take information such as your current and planned retirement ages, your preferred risk level for investments and the expected money needed during retirement to come up with a yearly suggested contribution amount for you to start saving. When using such a tool, keep in mind that stock market changes can affect your actual earnings over time, so the numbers shown aren't a guarantee.

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You'll want to open your desired type of retirement account so that you can begin contributing up to the limit allowed based on your chosen account type, age and any other rules that apply. If it's an employer-sponsored account, you can ask human resources about your options and any requirements to sign up and then designate how much money you want to be taken from your pay regularly. If you're getting an account on your own such as a Solo 401(k) or an IRA, you'll want to research brokers, follow the steps for opening the account and then either set up automatic deposits from a bank account or make the contributions as you desire.

When it comes time to do your tax return, you may need to report your retirement plan contributions so that the right tax benefits apply. For example, you'd need to report the year's traditional IRA contributions, which you can find through your broker's portal, so the money can be deducted from your taxable income for that year. You'd also need to report most 401(k) contributions, which you can find on your W-2 form, for similar tax benefits. Reporting your contributions can also help you qualify for the Saver's Credit if your income doesn't exceed the IRS limits.

A retirement savings plan is designed with the idea you won't access the money until you're at least ​59 1/2,​ and withdrawing money after that point comes with considerations for taxes owed based on the type of account and amount of money withdrawn. At the same time, the IRS has rules that you have to at least start taking out a required minimum amount of money from the retirement account by age 72 (unless still working for the sponsoring employer) or face a ​50 percent​ tax penalty on the money you fail to withdraw. However, the Roth IRA is one option that doesn't have this requirement.

Generally, you can expect to pay any taxes due along with a ​10 percent​ penalty for withdrawals before age 59 1/2 from most retirement account options. For example, you might qualify for an exception to the penalty due to a hardship such as a disability or the need to pay for certain expenses. Non-IRA plans may allow for loans where you can avoid some of the financial downsides of needing the money early as long as you adhere to the payback rules.

To withdraw your retirement plan funds, you'll want to check with your plan's administrator to learn about the specific retirement age for the account, any exceptions available and the process you'll need to go through to get the money. For example, you might withdraw your retirement savings from a 401(k) in a lump sum or agree to periodic payments. On the other hand, you might just withdraw cash from an IRA as needed.

​Read More​: How to Cash Out a 401(k) From a Former Employer