There are dozens of factors to consider as you're planning for retirement. How much should you be saving? What age should you retire? How much will you be receiving in Social Security benefits? One factor that's probably not among your top concerns, however, is where to stash your cash.
Not all retirement accounts are created equal, and choosing the right one could help you save more and spend less on fees and other costs. Traditional IRAs, Roth IRAs, and 401(k)s are some of the most common types of retirement accounts, and although they're similar in many ways, there are a few key differences between them. And understanding these differences can help you choose the right account for your needs.
Similar but not the same: Understanding retirement account options
Roughly 60% of workers have access to a defined contribution plan such as a 401(k) through work, according to the U.S. Bureau of Labor Statistics. With a 401(k), you can contribute tax-deductible dollars, let your money grow over time, and then pay income tax on withdrawals during retirement.
The primary benefit with a 401(k), though, is the potential employer matching contributions. If your employer offers them, your organization will match your 401(k) contributions up to a certain percentage of your salary. So, for instance, if you earn $50,000 per year and your employer will match your contributions up to 3% of your salary, that means you could be receiving $1,500 per year in what's essentially free money.
Another advantage of 401(k)s is that they have high contribution limits. In 2019, you can contribute up to $19,000 to your 401(k) -- compared to just $6,000 for a traditional or Roth IRA. And if you're age 50 or over, you can contribute an additional $6,000 per year to a 401(k), or just $1,000 extra to an IRA.
One downside to 401(k) plans, however, is the limited investment options. You're typically limited to just a few choices that are pre-determined by your plan administrator, and you could also be subject to high fees. Because you don't have any control over these factors, you may simply be stuck with less-than-stellar investment options and high fees if you want to invest your money in your 401(k).
With either a traditional or Roth IRA, you have much more control over where to invest your money. These types of accounts are highly customizable to fit your individual needs, and you can do some research to find accounts with the lowest fees -- so you can keep as much of your savings as possible.
IRAs also offer flexibility in how you prefer to be taxed. With a traditional IRA, your money is tax-deductible upfront, but you'll have to pay income taxes on withdrawals. Roth IRA contributions, on the other hand, are taxed upfront, but are tax-free when you withdraw your money. Because you're not taxed on Roth IRA withdrawals, you can keep your money in your account for the rest of your life -- unlike with traditional IRAs and 401(k)s, where you're required to start taking required minimum distributions at age 70-1/2 or face tax penalties (because the IRS wants its money eventually, after all).
The age at which you're allowed to make withdrawals without facing penalties also differs between accounts. With traditional IRAs and 401(k)s, you're subject to a 10% penalty plus income tax on any withdrawals you make before age 59-1/2. With a Roth IRA, you can withdraw the amounts you originally contributed at any time. However, you may have to pay a penalty for withdrawing any of the earnings you've made on those contributions if you're under age 59-1/2.
Choosing the type of account that's right for you
There are so many nuances to each type of retirement account, and it can be tough to decide which one to choose. There is one easy way to make a decision, however. If your employer offers a 401(k) with matching contributions, contribute at least enough to that account to earn the full match. Even if your plan has not-so-great investment options and high fees, the free money you're receiving more than makes up for it.
If you don't have access to a 401(k) or employer match (or if you've contributed enough to your 401(k) to earn the full match and want to invest the rest of your savings in a different account), there are a few key considerations when deciding between different accounts.
First, take a look at what you're paying in fees. Every account has fees (even though 37% of Americans mistakenly believe they don't pay any fees, according to a survey from TD Ameritrade), and choosing a retirement account with lower fees can save you thousands of dollars. The average person paying 1% in annual fees will spend around $138,000 in fees alone over a lifetime, according to research from the Center for American Progress, while fees of 1.3% will cause that number to jump to around $166,000. The Center for American Progress also found that average retirement account has fees of 1% of total assets managed, so if your 401(k) has a higher-than-average fee, it may be a good idea to look at other options.
If you're deciding between a traditional and Roth IRA, one thing to consider is what age you plan to retire. If you want to retire earlier than age 59-1/2, it may be best to choose a Roth IRA because you won't be hit with penalties by withdrawing your contributions. On the other side of the coin, a Roth IRA may also be a good choice if you're planning on working into your 70s and don't want to start taking required minimum distributions at age 70-1/2.
Your tax situation can be another deciding factor. If you're earning a high income now, the tax deduction with a traditional IRA may play in your favor if you're in a lower tax bracket come retirement time. That's because you'll end up paying less in taxes on your withdrawals than you would if you're taxed upfront with a Roth IRA.
There's a lot of information to consider when choosing a retirement account, but it all boils down to a few factors.
If your employer offers a 401(k) with matching contributions, make that account your first priority. Once you've maxed out the employer match, you can stick to your 401(k) if you're paying a reasonable amount in fees or if you plan to save more than the $6,000 per year you're allowed with an IRA.
If you don't have access to a 401(k) or if you choose to invest part of your savings in a different account, a Roth IRA is a good choice if you're planning on an extra early or extra late retirement (before age 59-1/2 or after age 70-1/2). Finally, a traditional IRA may be a solid option if you expect to be in a lower tax bracket than you are now once you start making withdrawals.
Choosing the right retirement account may seem like a difficult and confusing decision, but the most important thing you can do is to simply get started. Regardless of which type of account you choose, the earlier you start saving, the easier your retirement journey will be.