Retirees have many reasons to love their 401(k), but there may be even better accounts for you. Some investors should focus elsewhere, while others might benefit from some diversification. If your employer does not offer a 401(k)don’t worry: you still have great options.
The perfect account does not exist
Before delving into the merits of certain retirement accounts, it’s important to remember that no account is perfect for everyone. Each has features that might be attractive to particular individuals, depending on their circumstances. Often the best strategy is to combine multiple accounts to create balance and flexibility. It may be advantageous to have different retirement assets that allow you to diversify your tax exposure in retirement.
Instead of thinking of this as a general ranking, use this article as a guide to choosing the best products to get the most out of your overall retirement plan.
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1. Roth IRA
the Roth IRA it’s especially popular with younger retirement savers. Contributions to Roths are made in after-tax dollars, which means you won’t get any kind of tax deferral for these savings anytime soon. However, qualified withdrawals made after age 59½ are tax-free. Distributions from your 401(k) are subject to ordinary income tax, which takes a large portion of the net returns. If you anticipate high, long-term growth in your retirement savings, then a Roth account is probably the most tax-efficient account.
Roth IRAs also provide more flexibility in withdrawals. You have to pay taxes and penalties on any early withdrawal from a 401(k) that doesn’t get special exemptions. You can access any fund that has been contributed to a Roth without penalty, as long as the account is more than five years old. You cannot touch any winnings in the account without penalty, but the money you have paid can be accessed. That is a great advantage that creates functional liquidity and prevents you from running out of your own money.
Unfortunately, investors can only contribute $6,000 each year to a Roth IRA (or $7,000 if you’re age 50 or older). There are also income limitations, and the amount you can contribute is phased out above individual income of $129,000 or family income above $204,000. The restrictions are much less strict for 401(k) accounts. Also remember that individual accounts are not eligible for employer matching, which is one of the most attractive features of the 401(k).
2. Traditional IRA
traditional IRAs they also provide some benefits over a 401(k). These have identical tax treatment to a 401(k), and the withdrawal rules are similar as well. In that sense, there is no benefit that allows early access to tax-free savings or distributions.
The biggest advantages of traditional IRAs are investment flexibility and control. There is a long list of trusted brokers that will house your IRA. The best ones offer a wide range of investment options with low fees, which are great for investors. Most 401(k) accounts offer fairly limited investment options, although there are usually enough mutual funds and exchange-traded funds (ETFs) to support most people’s retirement strategies. More practical investors will prefer the flexibility and control of an individual account. This benefit also applies to Roth IRAs.
Obviously, IRAs create more liability for the individual investor. Make sure you are prepared 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 Roth accounts. But they don’t have income-based restrictions, which is great for higher-income households looking for deductions. As a result, you still won’t be able to match the total tax deferrals available in a 401(k), but there’s nothing to stop you from using both accounts.
3. Pensions and annuities
Pensions used to be standard for American workers, but have been disappearing in favor of 401(k)s in the private sector. Pensions were great because they took all the risk out of the individual. Savings in the plan were automatic, asset growth was centrally managed, and payments were guaranteed, usually for life.
Retirees didn’t have to worry, because someone else handled everything and the benefits were defined. Retirement income from pensions can mimic the cash flows of millions of dollars in investments. They are great plans if you have access to them.
Unfortunately, defined benefit plans have become 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 out in annuities, which can grow over time. In most cases, these products offer guaranteed payments for life once the income stream has been activated, usually during 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 much less efficient than regular investment accounts. They can also destroy your liquidity if used incorrectly. Still, the guarantees provided by annuities can be valuable pieces of many households’ retirement plans.
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