The 401(k) is often considered the pinnacle of retirement accounts, but for many savers, there's a better option waiting for them to claim it (or perhaps even more than one). Depending on your particular situation, a SEP-IRA, Roth IRA, or HSA may be a better place to store your retirement savings than a 401(k). Here's how to tell which of these accounts is the best fit for you.
The Simplified Employee Pension account, or SEP-IRA, is the best retirement savings account for most solopreneurs. Even if you don't identify yourself as self-employed, you may still qualify for a SEP-IRA. For example, if you're an employee but have a side gig as well, any income you make from your side gig counts as self-employment earnings for SEP-IRA purposes.
The SEP-IRA is a fabulous choice for two reasons. First, the contribution limits are potentially much higher than the limits of other retirement savings accounts. You can contribute up to $55,000 per year (for 2018), though your contribution is limited to no more than 25% of your self-employment income. And second, because you can make contributions to the SEP-IRA as the employer rather than the employee, these contributions don't count against your standard IRA annual limit. Thus, you can contribute to both a SEP-IRA and a Roth IRA at the maximum allowable level, whereas a traditional IRA and Roth IRA share an annual contribution limit. And SEP-IRAs share the advantages that all IRAs have over 401(k)s, namely, the much longer list of investment options and the ability to choose your IRA provider.
The one big drawback of SEP-IRAs is that you have to share and share alike. If you have employees, you have to give each of them a SEP-IRA and contribute the same amount to every account. For example, if you contribute 10% of your salary to your own SEP-IRA, you have to contribute 10% of each employee's salary to each of their accounts as well. However, since most solopreneurs don't have employees, this is often no problem at all.
The benefits of a Roth IRA are essentially the opposite of the benefits for traditional IRAs and 401(k)s. A traditional IRA gives you a lovely tax break on the money you contribute to the account, but when you take that money out, you then have to pay income taxes on it. Roth IRAs don't give you a tax break on your contributions, but your distributions are completely tax-free. This can work out to be a slightly better deal tax-wise because any interest and dividends that land in your Roth IRA never get taxed, whereas with a traditional IRA they get taxed when you draw them out (both kinds of IRAs don't tax dividends and interest at the time they come into the account).
Roth IRAs have another excellent benefit: you get your tax break after you retire, which is when you're likely to need it most. After all, as a retiree you're on a fixed and limited income and anything that can help stretch that income further can hugely improve your standard of living. What's more, because Roth distributions are considered nontaxable income, they can help keep your Social Security benefits from being taxed, too.
The health savings account, or HSA, is a special account paired with a high-deductible health insurance plan to allow you to save money for medical expenses. So, why is it in a list of great retirement accounts? Because the HSA is the only account that gives you a triple tax advantage.
As you learned in the previous section, traditional retirement savings accounts give you tax break on contributions but not distributions, while Roth accounts give you a tax break on distributions but not contributions. HSAs are the only account that can give you tax breaks on both types of transactions. And like IRAs and 401(k)s, the dividends, interest, and capital gains transactions in your HSA are also not taxed.
During your working years, you're required to use the money in your HSA only for qualified medical expenses, but once you turn 65, you can use your HSA money for anything you like. That makes the account a terrific choice for retirement savings as well as for minimizing healthcare costs.
Choosing your retirement account
Each of these three retirement accounts are so fabulous that you have to meet special requirements to contribute to them. SEP-IRAs require you to have self-employment income; Roth IRAs bar you from contributing if you exceed the income limits; and to contribute to an HSA you have to have an HSA-enabled high-deductible health insurance policy. However, if you qualify for such an account and then your circumstances change and you're no longer qualified to contribute, you keep the money that's already in the account -- and with HSAs, you can still spend these funds on qualified medical expenses even if you no longer have the right type of health insurance policy.
If you don't qualify for one or more of these accounts, then that inevitably narrows down your options. However, if you qualify for two or even all three types of accounts, your best course may be to open one of each type. These accounts complement each other beautifully; the SEP-IRA and HSA give you an immediate tax break, the SEP-IRA allows you to save an enormous sum for retirement, the HSA saves you money on medical expenses in the short-term, and the Roth IRA promises a significant tax break in retirement. Consider these three accounts the hat trick of retirement: open and contribute to all three, and you're maximizing your opportunity to save on taxes while looking forward to a fabulously well-funded retirement.