How to Save for Retirement Beyond a 401(k)
In a way, 401(k)s are the Band-Aids of retirement accounts. They’re what most people call the account they use to save for retirement, whether or not the account is a 401(k). Just as there are a wide variety of adhesive bandages of many brands available to you, there are a lot of different ways to save for retirement as well.
And because there’s no law requiring employers to provide this as a benefit in the first place, you may work for a company that offers you no means to save for retirement at all. Anyone who’s self-employed, or a freelancer or contractor (which is more than one-third of U.S. workers), also won’t have access to a 401(k).
To know if you’re saving enough for retirement in the right places, it helps to know what accounts are available to you, the tax ramifications of investing in those accounts, the maximum you can contribute each year, and when (if ever) you must withdraw money from them.
A 401(k) is just one piece of the puzzle — an important one, for sure, but not necessarily enough to build a comfortable nest egg without other kinds of retirement accounts in the mix.
The Wisdom of the 401(k)
Employer-sponsored plans like 401(k)s make saving for retirement relatively effortless, and you get some nice additional perks, too.
Once you open your account (the benefits person at your company can show you how to do this), your contributions are automatically deducted from your paycheck. You can change your contribution amount or investing asset allocation, or stop contributing entirely, at any time. When money is magically whisked away from your paycheck before it lands in your checking account, you won’t spend it on something else.
If your employer offers a match on your contributions, don’t pass up the opportunity to contribute enough to get the maximum match. It’s like a reward for being responsible!
Some employer-sponsored accounts allow you to contribute pre-tax income, saving you a considerable amount on your tax bill for the year.
Retirement accounts generally have contribution limits determined by the IRS, but employer-sponsored accounts generally have higher contribution limits than many individual retirement accounts. For example, you can contribute up to $18,500 to a 401(k) -- not including a company match — but only $5,550 to an IRA.
Why a 401(k) May Not Be Enough
Most workers today don’t get a traditional pension anymore (only about 4 percent have one as their sole retirement account today). That means most of us are on our own when it comes to funding our retirement accounts.
Even saving the $18,500 maximum contribution each year (which the vast majority of workers don’t do) may leave high income earners only saving a small percentage of their income for retirement.
When you estimate how much money you’ll need many years down the road, keep in mind that inflation will eat away at the value of your investments, and will also lower your gains.
Don't Forget to Consider Taxes
Taxes are something to consider, too. Accounts that allow pre-tax contributions simply delay your tax burden until you withdraw money in retirement. That means about 30 percent of your 401(k) will disappear, right when you need that money.
Tax Diversification and Why It's Important?
Contributing to a variety of retirement accounts with a combination of pre- and post-tax income helps you attain tax diversification in your retirement savings.
Simply put, this means that you’ll owe taxes on some of your retirement account withdrawals, and you won’t owe taxes on others.
This lets you strategize as to when to withdraw from which account in a way that’s advantageous to your tax bracket (which tends to be higher toward the end of your career and lower once you retire, unless you still earn income in retirement).
Alternatives to the 401(k)
Businesses benefit from providing retirement savings plans to their employees. It helps attract and retain talent, and employers get tax credits for establishing the plan and deductions for contributing to employees’ accounts. Win-win!
If you have an employer-sponsored retirement account, it may not actually be a 401(k), and that’s important to understand because some retirement accounts work in different ways.
Employers offer account types based on how many employees they have or what industry they’re in. You may or may not get an employer match to your contributions.
Alternatives: 403(b) Tax-Sheltered Annuity
If you work for a non-profit, public school, hospital, university, local government, or other tax-exempt organization, your employer may offer a 403(b).
These function similarly to 401(k)s, but they have lower administrative costs (which is beneficial to a non-profit employer). You can make pre-tax contributions of up to $18,500 a year and your employer may offer a match.
Alternatives: SIMPLE IRA
A Savings Incentive Match Plan for Employees Individual Retirement Account, or "SIMPLE IRA," are ideal for companies with fewer than 100 employees because the administrative costs are lower than a 401(k) plan, so they present less of a hardship for small businesses.
Employers must contribute either 2 percent of your income whether or not you also contribute (up to a $275,000 salary), or up to a 3 percent match of your contribution.
One downside is that you can only contribute up to $12,500 per year, which is significantly lower than a 401(k) or 403(b).
Alternatives: Roth IRA
You make post-tax contributions to a Roth IRA. Your investments grow tax-free, and you can withdraw the funds tax- and penalty-free after you turn 59.5.
Roth IRAs have some unique characteristics. First, there are no required minimum distributions, which is when you must take withdrawals from tax-advantaged accounts (and pay taxes on that money) when you turn 70.5.
Because of this, Roth IRAs can be ideal accounts for passing wealth down to heirs. Spouses who inherit Roth IRAs can roll the money into their own Roth IRA and won’t be required to withdraw any of it. Non-spouse beneficiaries can either take the money as a lump sum of cash, or roll it into an inherited Roth IRA -- but they must withdraw minimum distributions starting on Dec. 31 of the year after the original Roth owner died.
Roth IRAs can be used for purposes other than retirement. You can withdraw your contributions (but not the investment earnings) penalty-free any time if you’ve had your account for at least five years, making it an option for education or emergency savings. If you’re buying your first home, you can withdraw up to $10,000 of earnings penalty-free.
There are income limits that disqualify anyone earning over a certain amount from contributing to a Roth IRA: $135,000 for individuals and $199,000 for married couples.
Alternatives: Thrift Savings Plan
Federal government employees and members of the military can save for retirement with a Thrift Savings Plan. The TSP offer a choice of five index funds and several target-date funds, and extremely low expense ratios compared to the fund offerings in many other kinds of plans.
Members of the military get an automatic 1 percent contribution to their account, whether or not they contribute, plus an additional match on their contributions. Federal government workers automatically get 3 percent of their base pay deducted and deposited into their accounts (unless they were hired before Aug. 1, 2010, in which case they get a similar match to their contributions as military members).
Non-Employer Accounts
There are ways to save for retirement outside of your employer, which allow you to set aside even more money. IRAs (both Roth and traditional) allow you to save up to $5,500 per year. You have until tax day to make your contribution for the previous tax year, giving you some time to max these accounts out.
Because these accounts are intended for retirement savings, there is a 10 percent penalty for withdrawing money before you turn 59.5 (with some exceptions).
With IRAs, you get to decide which brokerage or bank you use. While employer-sponsored accounts may offer a limited selection of funds, some with very high fees, you get a much broader selection of investments for IRAs and brokerage accounts.
Non-Employer: Roth 401(k) and 403(b)
Many employers who offer a traditional, pre-tax 401(k) or 403(b) also offer a Roth option. In these accounts, you contribute post-tax income. When you retire, you can withdraw that money without paying additional taxes on it. You may choose to make some contributions to a traditional account and the rest to a Roth.
Why opt to pay taxes now instead of later? You may be in a lower tax bracket today than you expect to be in a few decades, which means a lower tax bill overall. It may also be easier for you to pay the taxes now, while you’re working, than when you’re on a fixed income in retirement.
Many younger workers opt for Roth 401(k)s because they haven’t yet reached their highest-earning years.
Non-Employer: Traditional IRA
Traditional IRAs allow you to make pre-tax contributions, and you can deduct your all or some contributions from your taxable income if you don’t participate in a tax-advantaged retirement account through work.
Your investments grow tax-deferred, and you can make penalty-free withdrawals beginning at age 59.5. Because you haven’t yet paid the taxes on this money, you are required to begin taking distributions from your IRA when you turn 70.5.
If your annual income disqualifies you from contributing to a Roth IRA, a traditional IRA could be a good choice for you instead.
Non-Employer: Taxable Brokerage
You’ll pay taxes on the gains when you sell investments (hence the “taxable” part), but these allow for total control over what you use the money in this account for. There are no penalties for withdrawing your money whenever you want.
You have your choice between traditional full-service brokerages, where you pay higher fees in exchange for professional investment guidance, or discount brokerages, where you handle your own investing but pay lower fees.
Whenever possible, max out any pre-tax accounts available to you before you invest in a taxable brokerage to maximize your tax savings.
Options for the Self-Employed
Sole proprietors, small business owners, and freelancers and contractors don’t benefit from employer-sponsored retirement accounts, and the $5,500 you can contribute to an IRA each year isn’t much.
Thankfully, special accounts allow anyone falling into these categories to set aside a considerably higher annual sum for retirement.
SEP-IRA
Self Employed: SEP-IRA
Your employer can contribute the lesser of 25 percent of your income or $55,000 to a SEP-IRA in your name. This means that if you’re a business’ sole worker or you’re a freelancer, you’re the employer contributing for the benefit of the employee... who is also you.
That’s a roundabout way to say you can contribute up to the limits in a SEP-IRA. However, if you run a business with other employees and you make a contribution to your own account, you must make contributions from your business to accounts for your employees. For a small business on a budget, this isn’t a decision to take lightly.
Self Employed: Solo 401(k)
Solo 401(k)s are for businesses with no employees other than the business owner and their spouse. It allows you to contribute $18,500 per year pre-tax, and your business to contribute up to 25 percent of your income (for a maximum combined contribution of $55,000).