What are the best retirement accounts for you?
Once you choose to start investing for retirement, the number of account type options can feel overwhelming. Reading through the names of the different categories can feel like it’s alphabet soup!
Choosing the best retirement accounts for you
Different retirement accounts have different rules, restrictions, benefits, and special qualities. Let’s dive in, look at the options, and decide which type is the best retirement account overall!
One quick disclaimer — this article is an overview for general information and entertainment purposes only. I’m going to discuss a lot of variables, options, and factors. Talk to a tax professional for personalized advice before selecting a retirement account type. Rules and regulations for each account type are subject to change on a yearly basis.
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Is a savings account a good way to save for retirement?
I often find myself using the phrase “saving for retirement” — but is a savings account really the best option?
Savings accounts are reliable. There’s virtually no risk that you’ll lose the money you deposit since qualifying US savings accounts are insured by the FDIC up to $250,000.
The simplicity is also attractive. Other savings strategies will involve more risk and asset evaluations than a savings account.
Ultimately, a savings account is not an appropriate place for the bulk of your hard-earned money, primarily due to inflation. Inflation in the US averages over 3% per year while the average savings account interest rate is about 0.1%.
This means that money sitting in an average savings account is actually losing 3% of its real value each year.
Savings accounts do not offer any tax advantages like the other accounts we’ll review below.
Plus, even the low interest rates available on savings accounts are subject to change.
The FDIC backing, in my opinion, is the most remarkable feature of a standard savings account. This makes savings accounts a good place to keep an emergency fund or savings for short-term goals.
Employer-sponsored defined contribution plans
Defined contribution plans are basically the reverse of a traditional pension plan.
Instead of receiving a fixed income from the investments like a pension offers (a “defined benefit”), you receive a variable return on your investment based on what you put into the plan (a “defined contribution”).
The investor is choosing (defining) what gets put into the investment account.
Many frequently used American retirement account types fall into this category, including 401k, 403b, 457b, TSP.
The main variation in these account types is which type of employee qualifies. 401k plans are offered to employees of business. 457b plans are offered to government employees while 457f and 403b plans are offered to employees of nonprofits and certain government workers. The Thrift Savings Plan (TSP) is for federal government employees including uniformed services personnel.
These defined contribution plans are tax-deferred. This means that contributions are (typically) tax deductible and you won’t owe taxes on the money or the growth until you withdraw from the account during retirement. This allows more of your money to grow for longer.
Perhaps the best feature of this type of account is that contribution limits are higher than IRA options. In 2020, the contribution limit is $19,500. This can be helpful if you have a large income, you’re hoping to invest a large portion of your income to retire early, or if you’re getting a late start with retirement savings.
Another major benefit is that employers often offer a match incentive to contributions to these plans. If your employer offers a match, that’s free money for retirement!
All tax-advantaged retirement savings accounts have some form of penalty to disincentivize investors from accessing the funds “too early”. If you make an early withdrawal without careful planning, you could be subject to a 10% penalty plus taxes on the funds.
However, there are ways to avoid the early withdrawal penalty.
These employer-sponsored plans are accessed through your employer, so you don’t have a lot of control over the brokerage or the investment types. Your investments might have higher expense ratios than what you could find in the open market.
Another factor to be aware of, especially as you approach retirement age, is that most retirement account types have required minimum distributions (RMDs). The rules are a bit complex but, basically, once you’re in your 70s you are required to withdraw a minimum amount from your retirement account each year — which usually creates taxes.
I mentioned above that you have less control over these plans since your access is through your employer. One solution is that, after you leave your employer, you can roll these tax-deferred plans into an IRA account.
We’ll talk more about IRAs, below, but you have more control over these plans and an IRA can allow different methods of avoiding the early access penalty.
One other special feature is that, if you are separated from your employer, you can access the funds in your employer-sponsored account without the penalty (if the separation occurred in or after the year you reach age 55, or age 50 for qualified public safety employees).
Note that this only applies to the account that you had through that employer, so any other accounts you may have wouldn’t qualify under that same rule.
Roth employer-sponsored plans
Most of these tax-deferred employer-sponsored plans have Roth options available — named for a former US senator who proposed the Roth IRA.
Roth plans offer a different tax approach to the tax-deferred accounts. In Roth plans, you contribute after-tax money to the plan, but then qualified withdrawals are tax-free.
Roth plans fall under the same contribution limits. So if you have a lot of money to invest for retirement, you can basically “buy” a tax advantage for the future by paying more taxes on the money in the present.
Non-Roth account withdrawals are usually taxed at your current income tax rate. So, under the current tax rules, Roth accounts are strategically beneficial if your income is lower now than it will be in retirement. In that scenario, you’ll pay the lower income tax on the money you invest, then you’ll avoid the higher taxes on the funds later in life.
This in itself doesn’t merit being on the “cons” list, but the problem for most investors is that (1) we don’t know what our income will be precisely in retirement and (2) we don’t know if the tax laws will be the same as they are now once we reach retirement. So, for younger investors, this can create a conundrum.
One other element to be aware of with Roth accounts is that any employer match will still be pre-tax, so you’ll be developing both Roth and traditional components to your savings. This isn’t a bad thing either, but it does introduce another variable.
I’ve already mentioned it, but it’s worth repeating — Roth accounts allow you to contribute after-tax dollars that grow tax-free for qualified distributions.
Another special feature of Roth accounts is that they usually do not have RMDs.
The traditional individual retirement account (IRA) gives the investor a lot of control and flexibility.
You can choose which brokerage to open the account with and which funds to invest in within the account.
Review the expense ratios and other management fees for your employer-sponsored plan. If they’re significant, you may want to consider investing some or all of your retirement funds in an IRA plan where you can find lower-cost options.
More people are eligible for IRAs, too, so they may be a good option if your employer doesn’t sponsor a retirement account.
Individual retirement accounts (IRAs) have lower contribution limits — $6,000 in 2020.
IRAs also do have RMDs and have lower income limits than employer-sponsored accounts.
If you want to access the IRA funds early, one helpful option is “rule 72t,” also called Substantially Equal Periodic Payments (SEPP). This rule can be a bit complicated and involves penalties if you change it once it’s set up, so, you’ll want to consult a tax professional before starting SEPP withdrawals.
Since traditional IRAs and tax-deferred defined contribution plans have similar tax structures, you can roll your employer-sponsored defined contribution account into an IRA after you leave the employer. This can give you more investment options, can help you consolidate your investments, and can give you access to options like SEPP.
Like the Roth versions of employer-sponsored plans, the Roth IRA allows you to contribute after-tax funds. Then, qualified withdrawals are tax-free.
Since this is an IRA account, the annual contribution limit remains at $6,000.
Growth and future withdrawals are tax-free.
Like other IRA accounts, the contribution limit is lower than employer-sponsored accounts.
Traditional IRAs do not have income limits, but there are income levels at which your contributions are no longer deductible. However, Roth IRAs do have firm income limits, so if you have a high income you may not be able to qualify to contribute directly.
There are a few unique features about Roth IRAs that make them appealing.
First, there are not required minimum distributions during the account owner’s lifetime. This can be helpful later in life if you don’t want to withdraw money from a certain account. So, for example, you could roll your IRA and defined contribution plans into a Roth IRA to avoid RMDs. This will be a taxable event, so speak with a tax professional before making a change like this.
Another great feature of the Roth IRA is that you can withdraw your contributions without taxes or penalties — even before you reach retirement age.
One final tool you can utilize with the Roth IRA is the Roth conversion ladder. The brief explanation is that you can roll your tax-deferred employer-sponsored accounts into a traditional IRA when you leave your employer. Then, with some thought and strategic timing, you can roll your IRA into a Roth IRA and reduce the total amount of taxes you owe. Check out this article from the Mad Fientist for more details.
Though not traditionally considered a “retirement account,” a Health Savings Account (HSA) can be worth considering as you plan for your later years.
If you have a high-deductible health plan (HDHP), you likely have access to an HSA. You can contribute pre-tax money to an HSA and, when you use it on qualifying medical expenses, it’s not taxed upon withdrawal either. So, if used correctly, these funds can be tax-free.
The tax structure of an HSA is similar to a Flexible Spending Account (FSA), except that the HSA has two main advantages. (1) Funds within an HSA do not expire at the end of the year, they can be maintained until later years. (2) Funds within an HSA can be invested in assets like mutual funds.
In many ways, an HSA is more like a retirement savings account than an FSA.
You do need to have an HDHP to contribute to an HSA, and that might not be appropriate for you in any given year. Consider if you expect significant healthcare expenses when choosing your plan and seek the advice of a professional before choosing an HDHP.
One unique property of an HSA is that you don’t have to reimburse yourself in the same year that the qualifying expense occurred. So, you can save your receipts then make tax-free withdrawals later during your early retirement years as a workaround to access those funds.
Another special feature is that HSA funds can be used for non-medical purposes, without a penalty, once you’re 65.
What should self-employed workers use to invest for retirement?
There are a few retirement plan options for self-employed workers that are worth considering.
If you’re self-employed, research the following plans and meet with a tax professional to decide what’s best for you: SEP IRA, Simple IRA, defined benefit plan, or Solo 401k.
Summary: what’s the best retirement account for Americans?
Overall, in my opinion, the Roth IRA and HSA offer the most powerful combinations of tax benefits and flexibility. In my book, it’s a two-way tie for the trophy!
However, it’s best to view each retirement account type as a tool in a toolbox. You want to choose the best tool for a specific job. So, look at your own present and future financial situations and decide which account is your best option to help you get there. Once you have looked at that, you can figure out which are the best retirement accounts for you.
The best option today might not be the best option for you in 5, 10, or 20 years. Your life and your financial standing will evolve. You may unexpectedly receive an early retirement package offer, receive a major promotion, or suffer a loss.
Don’t hesitate to re-evaluate, get expert opinions, or roll accounts into more appropriate types as your situation evolves and you become more wealthy.