Savings and Retirement: What kinds of tax-favored accounts are there?
Taxpayers have a variety of options for receiving tax benefits for retirement saving. Tax-favored accounts fall into two broad categories: those offered through an employer and those established by an individual. Accounts offered through an employer in turn are of two types. Defined-benefit plans generally distribute funds during retirement according to a formula that accounts for a worker’s years of service at a firm and earnings. In defined-contribution plans, of which the 401(k) plan is the most common, distributions depend on the size of past employee and employer contributions and on the investment returns on those contributions over time. Accounts established by an individual include two types of Individual Retirement Accounts (IRAs): traditional IRAs and Roth IRAs. Traditional IRAs and 401(k)s allow taxpayers to deduct the value of contributions, up to a limit, from taxable income, but tax the value of the distributions made during retirement. Contributions to Roth IRAs and Roth 401(k)s generate no immediate tax deductions but allow distributions to be received tax-free after the worker has reached retirement age. In all of these arrangements the accumulation of interest, dividends, and capital gains inside the account is not taxed.
- Employers are not required to offer their employees retirement benefits, and only about half of all workers do receive retirement benefits through their employer. Employees of large companies are more likely to receive employer-sponsored retirement benefits than employees of small firms. About two-thirds of workers at medium-size and large firms receive retirement benefits, compared with just one-third of workers at small firms. Almost all government employees receive retirement benefits.
- Worker participation in IRAs is less common. In any given year about one worker in twelve contributes to an IRA, although a higher percentage of workers own IRAs. Participation in IRAs is approximately evenly split between traditional and Roth IRAs.