Retirees have plenty of reasons to love their 401(k), but there might be even better accounts out there for you. Some investors should be focusing elsewhere, while others might benefit from some diversification. If your employer doesn’t offer a 401(k), don’t worry: You still have some great options.
The perfect account doesn’t exist
Before digging into the merits of certain retirement accounts, it’s important to remember that there’s no such thing as an account that’s perfect for everyone. Each one has features that could be attractive to particular individuals, depending on their circumstances. Often, the best strategy actually involves combining multiple accounts to create balance and flexibility. It can be advantageous to have different retirement assets that allow you to diversify tax exposure in retirement.
Instead of thinking about this as an overall ranking, use this article as a guide for choosing the best products to get the most out of your overall retirement plan.
1. Roth IRA
The Roth IRA is especially popular among younger retirement savers. Contributions to Roths are made with after-tax dollars, meaning that you won’t get any sort of tax deferral for these savings in the immediate term. However, qualifying withdrawals made after age 59 1/2 are tax-free. Distributions from your 401(k) are subject to ordinary income tax, which takes a big chunk out of net returns. If you anticipate high long-term growth in your retirement savings, then the Roth is probably the most tax-efficient account.
Roth IRAs also provide more flexibility on withdrawals. You have to pay taxes and penalties on any early withdrawals from a 401(k) that don’t get special exemptions. You can access any funds that have been contributed to a Roth penalty-free, as long as the account is more than five years old. You can’t touch any earnings in the account without penalty, but the money that you’ve paid in can be accessed. That’s a huge advantage that creates functional liquidity and keeps you from being locked out of your own money.
Unfortunately, investors can only contribute $6,000 each year to a Roth IRA (or $7,000 if you’re 50 or older). There are also income limitations, and the amount you can contribute is phased out above individual income of $129,000 or household income above $204,000. Restrictions are far less stringent for 401(k) accounts. Also remember that individual accounts aren’t eligible for employer matches, which are one of the most attractive 401(k) features.
2. Traditional IRA
Traditional IRAs also provide some benefits over a 401(k). These have identical tax treatment to a 401(k), and withdrawal rules are similar as well. In that regard, there’s no benefit allowing early access to savings or tax-free distributions.
The biggest edges for traditional IRAs are the investment flexibility and control. There’s a long list of reputable brokers that will house your IRA. The best ones offer a wide array of investment options with low fees, which are great for investors. Most 401(k) accounts offer fairly limited investment options, though there are generally enough mutual funds and exchange-traded funds (ETFs) to support most people’s retirement strategies. More hands-on investors will prefer the flexibility and control of an individual account. This perk also applies to Roth IRAs.
Obviously, IRAs create more responsibility for the individual investor. Make sure that you’re ready for it before you open an account. Do-it-yourself investors love the flexibility, because it can lead to higher long-term returns.
Traditional IRAs have the same annual contribution limits as Roths. But they don’t have any income-based restrictions, which is great for higher-income households looking for deductions. You still won’t be able to match the total tax deferrals available in a 401(k) as a result, but there’s nothing stopping you from using both accounts.
3. Pensions and annuities
Pensions used to be standard for American workers, but they’ve been disappearing in favor of the 401(k) in the private sector. Pensions were great because they removed all the risk for the individual. Savings into the plan were automatic, asset growth was centrally managed, and payouts were guaranteed, usually for life.
Retirees didn’t have to worry, because someone else handled everything and the benefits were defined. The retirement income from pensions can mimic the cash flows from millions of dollars worth of investments. They’re great plans if you have access to them.
Unfortunately, defined-benefit plans became unsustainable for many employers due to changes in capital markets and life expectancy. Today, less than 15% of all private-sector employees have access to defined-benefit plans. That shifts the responsibility of saving, investing, and distributing funds to the individual.
Annuities are insurance products that investors can use to mimic certain aspects of a pension. Assets are paid into annuities, which can grow over time. In most cases, these products offer guaranteed payments for life once the income stream has been turned on, usually in retirement. That’s a great way to eliminate longevity risk and investment risk for retirees.
Investors should be careful when considering annuity contracts. They tend to have high fees and can be a lot less efficient than normal investment accounts. They can also destroy your liquidity if they’re used improperly. Still, the guarantees provided by annuities can be valuable pieces of many households’ retirement plans.
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