Trying to sort through all of your retirement account options can be a daunting task. You start hearing terms like “401(k)” and “403(b)” and “IRA” and all of a sudden you feel like you’re drowning in an alphabet soup of random numbers and letters all mashed together.
Look, I hear you! It’s a lot to process. But choosing the right retirement accounts to hold your investments in is a big deal. It could mean the difference between enjoying tax-free withdrawals in retirement or having to pay Uncle Sam every time you open up your nest egg. There’s a lot at stake here!
How can you tell which retirement accounts are the right ones for you? Let’s find out!
Employer-Sponsored Retirement Accounts
If you’re like most working Americans, you probably have some sort of retirement fund available through the workplace. And many employers even pitch in to help you save for your retirement!
Let’s dive into some of the most common employer-sponsored retirement accounts out there, so you can figure out which plan works best for you.
A 401(k) is a retirement fund that companies offer you to help you save for retirement, and it’s the most common type of retirement plan in the workplace. Your 401(k) could contain any type of investment, but usually you’ll get to choose from a small selection of mutual funds that your company’s plan offers.
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There are two main types of 401(k)s—traditional or Roth—and the big difference between them is how they’re taxed:
- Traditional 401(k): These retirement plans are funded with pre-tax dollars and the money inside grows on a tax-deferred basis. That just means you won’t pay taxes on the money now, but you’ll be taxed on the withdrawals you take out in retirement.
- Roth 401(k): The money you put into a Roth 401(k) grows tax-free and you won’t pay any taxes when you take the money out in retirement. But hear me, only your contributions grow tax-free. If your company offers to match the money you put in (more on that in a minute), the money that your company puts in grows tax-deferred, so you’ll have to pay taxes on the match side of the account.
As of 2020, you’re allowed to put up to $19,500 each year into a 401(k). But if you are age 50 or older and need to catch up, you can put up to $26,000 in your account.1 You get to choose how much money you want to contribute to the plan, either a percentage of your salary or a set dollar amount, and that money will be taken out of your paycheck.
And many employers will offer a company match—that’s when your company offers to match a percentage of your retirement contributions in your 401(k). Translation? Free money! I don’t know about you, but I get excited about free money.
One last thing you need to know about 401(k)s is that you can’t withdraw money from the account until you reach age 59 1/2.2 If you do decide to crack open your nest egg before then, you’ll get hit with a penalty by the IRS. So until then, leave that money alone, people!
If you have a job at a nonprofit or tax-exempt organization—I’m talking to teachers, government employees and some nurses and doctors here—you might have a 403(b) plan instead of a 401(k).
A 403(b) and a 401(k) basically work the same way. They both have the same contribution limits, early withdrawal penalties, similar tax treatment, and 403(b)s can be either traditional or Roth accounts. So nearly everything I said about 401(k)s applies to the 403(b) too.
But there’s one thing with a 403(b) to be cautious about: the investment options. Sometimes these plans can be loaded with insurance products like annuities that have low returns and expensive fees and surrender charges. Steer clear of those and stick with good growth stock mutual funds!
Thrift Savings Plan (TSP)
The Thrift Savings Plan gives federal workers and members of the military the opportunity to invest in a tax-advantaged account for retirement. Just like a 401(k) or 403(b), TSP contributions (which can also be Roth or traditional, by the way) can be taken straight out of your paycheck.
Now, the TSP offers five different individual fund options for you to choose from, each one invested in either short-term U.S. Treasury securities or U.S., international, or bond index funds.
- The Government Securities Investment (G) Fund
- The Fixed Income Index Investment (F) Fund
- The Common Stock Index Investment (C) Fund
- The Small Capitalization Stock Index (S) Fund
- International Stock Index Investment (I) Fund
I’d recommend sticking with a mix of C, S and I Funds, with 60% invested in the C Fund, and 20% each going into the S & I Funds.
Also known as “defined benefit plans,” pension plans use a formula based on your salary history and length of employment to calculate a guaranteed payout in retirement. With these types of plans, the risk is on the employer to save and invest the contributions. All you have to do is do your job, stay loyal to the company, and in exchange you get a gold watch and a pension check every month when you retire.
But that was back in the good ol’ days. Today, the pension is an endangered species—replaced by “defined contribution plans” like the 401(k) and 403(b) in most workplaces. Baby boomers, union members and public sector workers (government, police, teachers, etc.) make up the majority of pension-holders today.
The problem is that pensions aren’t always a safe bet. I’ve seen some companies and governments scale back pension benefits because they’re in financial trouble or mismanaged their investments. That’s not right! And if you wanted to leave your company for a new job, you’ll still see some pension money in retirement but not as much as you originally expected.
So if you have a pension plan, just be careful—they’re not always a slam dunk. You might want to sit down with an investment professional regularly to figure out if your pension is going to be enough for your retirement future.
Do-It-Yourself Retirement Accounts
Now it’s time to go outside the walls of your workplace and talk about some of the retirement accounts you can open up on your own and with the help of an investment professional.
Individual Retirement Arrangement (IRA)
Individual Retirement Arrangements (IRAs) are retirement savings accounts that allow you to save for retirement outside of your workplace retirement plan with some nice tax advantages. And while most workplace plans only let you choose from a handful of investment options, you can choose to have almost any kind of investment inside of your IRA, including mutual funds, annuities or even real estate.
There are two main types of IRAs for you to choose from: traditional IRAs and Roth IRAs. Here are some rules that apply to both types of accounts:
- In 2020, you can put up to $6,000 in your IRAs ($7,000 if you’re age 50 or older).
- You’ll pay an early withdrawal penalty on any money you take out of an IRA before age 59 1/2.
- You can put money in at any age. 3
But there are some major differences between traditional and Roth IRAs! Let’s take a closer look at both to see which one is the better choice for you.
Traditional IRAs are invested with pre-tax contributions, which means you’ll be able to claim them as tax deductions now, but you’ll have to pay taxes on the money you withdraw in retirement later. And you can’t keep the money parked in your traditional IRA forever—you have to start making withdrawals at age 72 (Uncle Sam wants his fair share).4
One of the nice things about traditional IRAs is there are no income limits on contributions, which means you can put money into your IRA no matter how much money you make!
I’m going to come right out and say that I love Roth IRAs! Since they are invested with after-tax dollars, that means the money you invest grows tax-free and you won’t owe any taxes when you withdraw that money in retirement. I like the sound of that already! And there are no required minimum withdrawals (RMDs), since you’ve already paid taxes on the money you put into a Roth IRA.
Unfortunately, you won’t be able to put money in a Roth IRA if your income is too high. For 2020, those income limits are $196,000 for married couples filing jointly or $124,000 for single people.5
There is a way around that rule, and it’s called a backdoor Roth IRA. And don’t worry, it’s perfectly legal! Here’s how it works: First, you open up a traditional IRA or put money into one you already have. Then, as soon as that money is in your traditional IRA account, ask your investment pro to convert that IRA into a Roth IRA. When you do that, you’ll have to pay the taxes on that money, so make sure you have the cash on hand to pay what you owe!
Taxable Investment Accounts
Taxable investment accounts (like a brokerage account) offer something that classic retirement plans like a 401(k) or an IRA don’t, and that’s flexibility.
First, there are no income limits—anyone with a couple hundred bucks and a pulse can open an account with a brokerage firm. And second, you can take money out of a taxable investment account at any time for any reason without getting slammed with early withdrawal penalties. That makes taxable investment accounts a great option if you’re looking for ways to retire early.
But hold the phone! There’s one huge drawback to using taxable investment accounts, which is that you’ll pay taxes on any money your account earns. That’s why you should only consider using taxable investment accounts for retirement after you’ve maxed out your tax-advantaged options like a 401(k) or an IRA.
If you’ve maxed out your 401(k) and IRA and still haven’t hit 15% of your gross income, or if you’re looking for someplace to invest beyond 15%, investing in good growth stock mutual funds inside a taxable investment account is a good option to help you hit that mark.
Retirement Accounts for Small Businesses and the Self-Employed
More and more Americans are working for themselves as contractors, freelancers and small business owners. Many others work for a small business that might not have the resources to offer a full-fledged 401(k) plan yet.
Listen to me, just because you don’t have access to a 401(k) doesn’t mean you’re out of options. The good news is that you do have some options!
If you’re self-employed and don't have any employees, a one-participant 401(k)—also known as a solo 401(k)—was designed with you in mind. You can contribute up to $19,500 every year (or $26,000 if you’re age 50 or older), and those contributions are tax-deductible. Then, on top of that, you can put in an additional “employer match”—up to 25% of your income—as long as your total contributions are less than $57,000 per year.6
Once you start hiring employees to help you take your business to the next level, that changes things. Now it’s not just your retirement you have to worry about—you have to start thinking about how to help your employees save for retirement too. That’s a big deal! And a SIMPLE IRA can help with that.
A SIMPLE IRA is basically a start-up retirement savings plan for small businesses. This plan makes it easy for small business owners to save for their own retirement and contribute to their employees’ retirement savings as well.
As of 2020, employees can save up to $13,500 into the plan (anyone age 50 and older can put in an extra $3,000 as a catch-up contribution) while the employer is usually required to offer up to a 3% match for their employees every year.7
A simplified employee pension (SEP-IRA) is another retirement plan option for small business owners or self-employed individuals, offering many of the major tax advantages of a traditional IRA.
Unlike a SIMPLE IRA, which allows both employers and employees to contribute to the plan, only employers are allowed to contribute to the plan on behalf of their employees. For 2020, employers are able to contribute up to 25% of an employee’s salary to their account each year, up to a total contribution of $57,000.8
Which Retirement Accounts Are Best for You?
Phew! OK, I just threw a lot of information about a bunch of different retirement accounts at you. But the question remains: Which retirement accounts work best for you?
Honestly, the answer depends on your situation. An employee at a large company has different options than a freelance photographer. You’ll want to meet with a qualified investment professional who can help you make the right decision.
But no matter who you are, I recommend investing 15% of your gross income for retirement in good growth stock mutual funds (once you’re out of debt with a fully funded emergency fund).
Here are my general guidelines for how to make the most of your retirement account options, especially if you have access to a workplace plan.
Step 1: Take Advantage of Your Company Match
If you have an employer-based plan like a 401(k) at work with a company match, start by investing there up to the match.
Let’s say your company offers a 4% match. If you earn $60,000 a year and take advantage of your match, that’s an extra $2,400 a year being invested for retirement! Once you’re ready to start investing, the first thing you should do is invest in your 401(k) up to the company match. But do not count that employer match as part of your 15%—that match is just the cherry on top of your sundae.
Listen, if your company offers a Roth 401(k) option, that’s a deal too good to pass up. Take it! If you like your investment options in your Roth 401(k), you can simply invest your entire 15% there and you’re done.
What if you don’t have a company match at work? Then you’ll start investing with a Roth IRA first and max out that account before investing in your 401(k).
Step 2: Open Up a Roth IRA
Once you’ve invested up to the company match, it’s time to move on to my favorite retirement account—the Roth IRA. Remember, the Roth IRA lets you enjoy tax-free growth and tax-free withdrawals in retirement. Don’t miss that!
If you’re a high-income earner, you might not be eligible to open up or contribute to a Roth IRA. That’s okay! You can go with a traditional IRA instead.
Step 3: Go Back to Your Workplace Plan
So, what happens if you max out your Roth IRA and still haven’t hit 15%? If that happens, you can go back to your workplace plan and invest there until you hit 15%.
That’s it! Between your employer-sponsored plan (401(k), 403(b), etc.) and a Roth IRA, you should be able to save enough money for retirement while enjoying the tax benefits both accounts have to offer.
Work With an Investment Pro
Choosing the right retirement accounts is a huge step that will help you get closer to turning your high-definition retirement dream into a reality. And you don’t have to make these decisions on your own!
Our SmartVestor Pros will sit down with you to help you select retirement accounts that make sense for you.