Which Retirement Account Is Best for You?
by , CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
April 11, 2012
I'm trying to be smart about investing for retirement, but I get confused by all the different accounts out there. Help!
I believe saving for retirement is one of the smartest things you can do, so kudos for asking this question. You're right that there is a confusing array of retirement account choices out there, but the good news is that they all have benefits that can help you save. There's no right or wrong choice—only the choice that makes sense for your personal situation.
One good way to understand your choices is to look at the tax characteristics of different accounts.
Tax-deferred accounts give you upfront benefits
Probably the most well-known retirement accounts are the 401(k) and the traditional IRA. These are tax-deferred accounts, which means you won't pay income taxes until you withdraw the money, preferably when you’re retired. At that time, you'll pay taxes at your ordinary tax rate. (Note: You generally will be charged a 10 percent penalty on top of income taxes if you make a withdrawal before age 59½)
Now let's look at the different types of tax-deferred accounts. Here are some of the most common:
Tax-free accounts give you a break down the road
- 401(k)—This is offered through an employer. You designate a percentage of your pretax income (meaning that you won't pay taxes on this money) to be automatically deposited into your account each month. Often an employer will match a percentage of your contribution. You then generally have a choice of investments. The current maximum annual contribution is $17,000 ($22,500 if you're 50 or over). You are required to start taking annual distributions at age 70½. Nonprofits and tax-exempt organizations offer similar accounts, such as a 403(b) and a 457, which have the same general characteristics.
- Traditional IRA—This account is available to individuals with earned income or their spouses. The maximum yearly contribution is $5,000 ($6,000 for those 50 and over). You may get an upfront tax deduction, depending on your income and whether you are part of an employer-sponsored plan. You can only contribute to a traditional IRA up to age 70½. Like a 401(k), at 70½, you're required to start taking annual minimum distributions.
- SEP-IRA, SIMPLE-IRA, Individual 401(k)—If you're self-employed or own a small business, you have a choice of several tax-deferred retirement accounts depending on your circumstances. Annual contribution limits vary, but are generally higher than a traditional IRA.
A popular alternative to a tax-deferred account is a tax-free Roth account. Contributions to a Roth are made with after-tax dollars (no upfront tax deduction) but earnings grow tax-free, and withdrawals after age 59½ are income tax-free once you’ve held the Roth for five years.
You can contribute to a Roth IRA if your income is less than $125,000 for a single filer or less than $183,000 for married filing jointly. Some employers are now offering a Roth 401(k) or a Roth 403(b)—with no income limitations for participating. Contribution limits are the same as for traditional IRAs and regular 401(k)s.
A Roth IRA or a Roth 401(k) can be particularly attractive if you're young and expect to be in a higher tax bracket when you retire. That's because an upfront tax deduction may not be that significant in your early working years when you're earning less—but tax-free withdrawals could be very welcome later on, especially if future tax rates go up. Another consideration is that there's no age limit for contributing to a Roth IRA and no required minimum distribution. (Age limits and minimum distributions do, however, apply to Roth 401k's and Roth 403(b)'s, unless you are still working.)
Taxable accounts give you additional flexibility
The tax advantages of retirement accounts can potentially help your savings grow faster, but a taxable brokerage account has its pluses, too. There are no income or age limitations and no restrictions on when you can withdraw your money. You have a wider choice of investments. And while there are no initial tax breaks, you pay taxes at the capital gains rate when you realize a profit—currently a maximum of 15 percent for investments held more than one year.
All of them can work together
Fortunately, you don't necessarily have to choose one account over another. For example, you could have a 401(k), a Roth IRA and a taxable account all working for you. That would give you both taxable and tax-free income at retirement—a sort of tax diversification. If you're lucky enough to be able to save in more than one, I'd start with your 401(k) to make sure that you capture your entire employer match. Then you can either continue to contribute to your 401(k) or invest in an IRA or taxable account. Whatever your situation, don't delay. Whether it's in a tax-deferred, tax-free or taxable account, your best choice is to save as much as you can as soon as you can!
The information on this website is for educational purposes only. It is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.