An employer-sponsored 401(k) plan is one of the easiest ways to start socking money away for retirement, but if you don’t have access to one, there are other options.
When it comes to retirement savings, the most important thing is to get started—after all, time is one of your greatest assets. If you are offered a 401(k) at work, signing up is a no-brainer. However, one in three employees at private companies don’t have access to a plan.1
If that’s your situation, an Individual Retirement Account (IRA) is probably your best bet. They come in a few versions, but traditional and Roth IRAs are the most popular.
This is a great time to act: If you want to open a traditional IRA to set aside some 2020 income, you’ll need to do it before April 15, 2021.
Like 401(k)s, IRAs provide tax benefits as an incentive for you to sock away cash for use in retirement. Usually you can’t tap these funds until age 59 ½ without facing a penalty, but there are some exceptions.
With most IRAs, there is no potential for a company match— the main feature that can make 401(k)s such a great benefit at some companies. Another key difference is that 401(k)s have significantly higher contribution limits, enabling you to sock away more per year and the plan may have a loan provision to borrow funds without currently paying income taxes on the distributions. Also, the tax benefits of IRAs tend to phase out if you make more than a certain income threshold, especially if your company offers a 401(k) option.
Note that you can contribute to both a 401(k) and an IRA, up to certain limits. That means you could potentially fund your 401(k) and also max out your IRA.
When you open an IRA, you need to decide if you want it to be “traditional” or “Roth” in structure. The big difference between the two is in how the government taxes your investments.
With a traditional account, your contributions reduce your taxable income this year. So, if you make $100,000 and contribute $5,000, you’d only be taxed as though you made $95,000 in income. Down the line when you’re ready to retire, you’d have to pay income taxes on the amount you withdraw each year.
With a Roth IRA, your contributions don’t provide a short-term tax break, but with your investment the potential earnings on your investments grow tax free (if certain requirements are met). So, if you make $100,000 and contribute $5,000 to a Roth account, you’d still be taxed on the full $100,000 this year. But when you’re ready to retire, you’d be able to withdraw your money without paying any taxes. Note that the amount you can contribute to a Roth declines the more you make. Single filers who make more than $140,000 in 2021 or married filers who make more than $208,000 can’t contribute.
Roth accounts tend to especially benefit younger people and those in a fairly low tax bracket now, on the assumption that they’ll probably be higher earners (facing higher taxes) when they’re retirement age. More companies are offering Roth options to their 401(k)s.
While these accounts, no matter which one you choose, are meant for retirement savings, keep in mind that there are some instances in which Roth contributions can be withdrawn before retirement without penalty and tax. Also, first time homebuyers may be able to withdraw up to $10,000 to fund the purchase. If you’re starting to save now for a retirement that is decades in the future, you may find that reassuring.
IRAs do have one advantage over 401(k)s that may be appealing to some investors. You can choose where you would like to hold the account and have far more investment options than many 401(k)s.