Choosing a Retirement Account: What's Available, and What’s Best for You?
You know you need to save for retirement, no matter how many years away retirement is for you. But understanding your choices and picking the right account may seem daunting.
The most popular and talked about retirement accounts are the 401(k) and the Roth IRA. Both of these have well-deserved, mostly positive reputations. Many financial advisors recommend that you participate in your employer's 401(k) plan so you can:
- Receive matching contributions from your employer, boosting your retirement savings with no extra effort on your part
- Reduce your taxable income by the amount of your plan contributions (also known as "elective deferrals"), which lowers your tax liability
- Enroll in automatic payroll deductions to fund your account, making the entire process after the set-up mindless
The Roth IRA is touted for different reasons. By contributing to this account, you can:
- Receive tax-free distributions in retirement (you'll pay ordinary income taxes on distributions from traditional accounts)
- Access funds with fewer restrictions and tax consequences compared to other retirement plans (see article on Roth IRA withdrawals and IRS rules)
The downsides to these choices are that you have limited investment options and potentially high fees with the 401(k) plan while you don't get a tax deduction right now with the Roth IRA.
But wait, there are even more nuances to consider.
For example, your employer may not offer matching contributions or even have a 401(k) plan, or you may earn too much for a Roth IRA. So, you should figure out what types of accounts are available to you, sort through their features, and then pick the one (or ones) that are best for you. Let's get started! (See also: 6 Ways to Avoid Running Out of Money in Retirement)
Retirement Accounts and Their Features
There are various ways of categorizing the universe of retirement account options. An account may be employer sponsored or independent of your workplace. Contributions may be tax deductible when you fund the account (traditional) or distributions may be tax free in retirement (Roth). Your account may be characterized by defined contributions (such as an IRA with rules about the amount you can put in the account during your working years) or defined benefits (such as a pension plan with a specified payment stream in retirement).
Features that you should evaluate before choosing an account include:
- Contributions: Do you contribute to the account, does your employer, or both? Are there income or other eligibility restrictions to participate and make contributions?
- Tax Benefits: What are the tax benefits of the account? Are these benefits restricted based on income or other requirements?
- Investment Choices: Are you responsible for making investment decisions, and what are your investment choices?
- Fees: What are the fees associated with the account?
- Ownership and Access: Do you have full rights to the assets in the account immediately, and, if not, what is the vesting schedule? Can you access funds through a participant loan or withdrawal before retirement?
To get the complete story on your account options, you'll need to read documents associated with plans sponsored by your employer, look at the types of accounts and investment selections offered by your financial institution, and consult with a financial and/or tax advisor.
But, in general, the following retirement accounts have common characteristics.
Traditional 401(k) Plan
- Contributions: As an employee, you can contribute up to $17,500 per year. Your employer may also make a matching contribution. Combined annual contributions are capped at $51,000 or 100% of the employee's compensation. Catch-up contributions of up to $5,500 for those 50 or older can also be made. (Note that IRS restrictions may change based on cost-of-living adjustments.)
- Tax Benefits: Your contributions reduce your taxable income when you fund the account. Earnings are tax deferred.
- Investment Choices: You choose from a list of investment selections offered by your employer, the plan sponsor. Typically, these choices include mutual funds.
- Fees: Expenses include 1) plan administrative fees; 2) investment fees, which may include sales commissions for mutual funds; and 3) fees incurred on specific transactions, such as borrowing from the account.
- Ownership and Access: You own the funds you contributed to the account, but your employer’s contributions may not be 100% available until you are fully vested. Borrowing is generally permitted but loan provisions are dictated by the plan's design. Distributions may be taken prior to retirement if you qualify for a financial hardship.
Retirement Accounts Similar to the Traditional 401(k) Plan:
- The 457(b) Plan may be offered to employees and independent contractors of state and local governments and non-profit organizations.
- The Thrift Savings Plan is offered to federal government employees and members of uniformed services. Qualifying employees may receive matching contributions from their agencies.
- The 403(b) Plan may be available to employees of public schools, certain non-profit organizations, and others. However, investment options may consist of annuities in addition to mutual funds.
- The Safe Harbor 401(k) Plan is nearly identical to the 401(k) plan from an employee’s perspective. However, funds contributed by employers are always fully vested.
- The Individual or One-Participant 401(k) is available to the self-employed. You can contribute the lesser of 25% of your income or $51,000 annually.
- Roth 401(k)s are designated Roth accounts held inside of a 401(k). However, contributions are not tax deductible. Qualified distributions are excluded from income in retirement.
An Individual Retirement Arrangement (IRA) gives you a vehicle to save money for retirement in a way that is not tied to an employer or specific job.
- Contributions: All contributions are made by you and are limited to $5,500 per year (or $6,500 per year for those who are 50 and older).
- Tax Benefits: You may be able to take a tax deduction for contributions, and earnings are tax deferred. Deductions are limited or eliminated for higher earners depending on your income, tax filing status, and availability of a retirement plan at work. (See tables to determine eligibility for those covered and not covered by a retirement plan at work.)
- Investment Choices: You can choose from investment options offered by your bank, brokerage firm, or other financial institution. These might include mutual funds, ETFs, individual stocks, and CDs. Real estate can also be held in an IRA.
- Fees: You may incur account opening or maintenance fees, although many online brokers have no-fee IRAs. Investment costs may include stock trading fees as well as costs to purchase and redeem mutual funds.
- Ownership and Access: You own the account, and all the money is yours. Participant loans are not permitted. Withdrawals prior to retirement can be made but are subject to a 10% penalty in addition to ordinary taxes associated with the distribution. There are exceptions that allow you to avoid the penalty.
Retirement accounts similar to the Traditional IRA:
- The Payroll Deduction IRA is a regular IRA but involves setting up a payroll deduction with your employer to fund the account.
- The SEP-IRA is available to those who have self-employment income or work for a small business that offers the SEP as its retirement plan. Annual contributions can be made by the business owner only, generally up to $51,000 or 25% of your annual income, whichever is less.
- A SIMPLE IRA allows both you and your employer to contribute to your IRA. You can contribute up to $12,000 each year plus $2,500 for catch-up contributions for those 50 and older. Employer contributions are typically 3% but may vary by plan.
- Rollover IRAs are accounts that have been created by transferring funds from 401(k) or similar plans to an IRA. (See also: Step-by-Step Guide to Rolling Over Your Old 401(k))
- The Roth IRA has many of the traditional IRA features. However, contributions are not tax deductible and qualified distributions are not subject to taxation. Also, you may not be able to contribute if your income is too high. (See table to determine the amount of Roth IRA contributions you can make.)
A pension plan is a commonly recognized defined benefit plan, which specifies the benefit you receive in retirement. Benefits are determined by a formula usually based on years of service and earnings while employed.
- Contributions: The employer typically makes contributions on behalf of employee participants. Contributions from employees may be required or voluntary. Plan administrators make sure that contributions support the benefit that is promised to employees upon their retirement.
- Tax Benefits: There are no special tax benefits for employees.
- Investment Choices: The employer chooses the investments. Investment risk is largely borne by the employer, which must ensure that funds are available to provide employees with a specific amount of money.
- Fees: Expenses are paid by the employer.
- Ownership and Access: Your rights are dictated by the plan's design. Typically, you must work for the sponsoring employer for a certain number of years before becoming fully eligible to receive benefits in retirement. Participant loans may be permitted; in-service withdrawals are not allowed.
Retirement Accounts Similar to the Pension Plan:
- A Cash Balance Plan offers a defined benefit. However, this benefit is reported in terms of account balances (rather than a monthly payment) for each employee. Upon retirement, the employee can typically opt for an annuity or a lump-sum payment.
More Employer-Sponsored Plans
There are many more types of retirement plans that you may encounter during your career.
- A Money Purchase Plan requires that your employer contribute a set percentage of your annual income each year to the retirement account. This contribution cannot exceed 25% of your income or $51,000. As an employee, you may be able to make non-deductible contributions to the plan. Participant loans are permitted but in-service withdrawals are not allowed.
- The Profit-Sharing Plan is similar to the Money Purchase Plan but does not have mandated contributions and employees cannot make contributions. The annual contribution amount may vary but must follow a formula so that profits are equitably distributed to all employees. In-service withdrawals are permitted.
- The Employee Stock Ownership Plan or ESOP allows employers to contribute company stock to a retirement plan on behalf of its employees. Over time, employees become vested in the plan; that is, you take full ownership of the stock given to you.
Choosing a Retirement Account
Figuring out where to stash your money could start with a review of the retirement accounts offered by your employer. Look at the benefits, if any, offered without your contribution such as a pension plan or ESOP. Research the quality of your 401(k) or 403(b) by looking at plan reports and using online evaluation tools such as Bright Scope; note the employer match in particular.
Additional factors in your decision may include:
- Comfort in choosing investments and managing your own portfolio
- Uncertainty about future employment, particularly if you want to change jobs, return to school, travel, or stay at home with children
- Sources and amounts of annual income
For general guidance, look at your current situation, state of mind, and plans for the future.
If you are…
- Really Busy: Use payroll deduction to participate in your employer's 401(k) or similar plan, particularly if you receive a match. Open an IRA when you have more time.
- Controlling: Sock away money in an IRA so that you can invest at your discretion. A Roth IRA will give you better-than-average control over funds if you need access later, plus allow you to take distributions at your discretion and avoid taxes in retirement.
- Eager: Open, fund, and manage as many accounts as you can, recognizing that contribution limits are combined for various types of 401(k) and similar plans as well as IRAs.
- Transient: If you know that you will be changing jobs soon, invest in an IRA so that you can avoid the hassle of doing a Rollover IRA. Plus, you may have to forgo some or part of the company matches anyway if you leave before becoming fully vested.
- Uncertain: Put enough in the 401(k) or similar plan to get a company match, and designate half of your money to a Roth within the plan if possible. Split your IRA contribution into Traditional and Roth accounts.
- Self-Employed: Start a One-Participant 401(k) plan or SEP-IRA to save self-employment and/or business earnings.
- High Earning: Set aside money in a designated Roth account within a 401(k), especially if you are a high earner who would otherwise not qualify for a Roth IRA. You can afford to pay taxes now in order to avoid them later.
The best place to put your retirement dollars may vary from year to year and change as your retirement portfolio and other assets grow. By understanding the features of various retirement accounts, you can decide what works for you.