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When it comes to planning for retirement, most people understand that they need to open an investment account of some sort.
But, with all the acronyms out there–IRA, 401(k), SEP, etc – it can be difficult to know which account is best for you. This often leads to paralysis by analysis, and then you end up doing nothing at all.
Sound familiar?
In this article, I'll cover the pros and cons of different retirement accounts so you can potentially determine for yourself what type of account is best for retirement.
Let's dive into the details.
Types of Retirement Accounts
Here are all the accounts that we will discuss in this article:
Defined contribution plan (401k, 403b, 457b)
Traditional retirement accounts (IRAs)
Individual brokerage account
Other retirement account options
What Type of Account is Best for Retirement?
There is no particular account that experts consider the “best” for retirement. Instead, there are a handful of different options that are all tailored for different financial situations while still providing similar advantages.
In practice, we've found that having your retirement savings in multiple account types with different taxation is the best option. This allows for greater flexibility when you end up withdrawing money from your accounts in retirement.
To find the best account for retirement based on your personal situation, we recommend that you request a free retirement assessment from one of our experienced financial advisors.
The type of retirement account that is best suited for your specific situation depends on several key factors:
Age and Retirement Timeline: Younger individuals might prefer accounts with higher growth potential over the long term, while those closer to retirement age may opt for more conservative options.
Income Level: Different accounts have varying income limits and tax advantages. High earners might benefit more from certain types of accounts than low or middle-income earners.
Employment Status: Whether someone is self-employed, a small business owner, or a salaried employee can impact the choice of retirement account, as different accounts offer distinct benefits and limitations for each employment category.
Tax Situation: The choice between a Roth (post-tax contributions) and a traditional (pre-tax contributions) retirement account can depend on current and expected future tax rates. Those expecting higher future taxes might prefer Roth accounts.
Investment Preferences: Some individuals prefer to have more control over their investments, while others are content with more standardized options provided by employer-sponsored plans like 401(k)s.
Contribution Limits: Different accounts have different limits on how much one can contribute annually. This can affect how much one is able to save for retirement.
Access to Employer Match: Some employer-sponsored plans, like 401(k)s, often include an employer match, which can significantly boost retirement savings.
Liquidity Needs: Considering how accessible the funds are before retirement age is important. Some accounts have strict penalties for early withdrawal.
Estate Planning Considerations: How retirement savings will be handled in terms of inheritance can also influence the choice of account.
Future Financial Goals: Other financial goals, like saving for a child’s education or a major purchase, can also impact the choice of retirement account.
Social Security Benefits: Understanding how a retirement account will interact with Social Security benefits is also a key consideration.
Each of these factors can heavily influence the decision-making process when choosing the most suitable retirement account for an individual's needs and goals.
With that said, let’s explore the most popular types of retirement accounts.
Defined Contribution Plans: 401(k), 403(b), 457(b)
Defined Contribution plans are best for employees who are looking for the easiest way to save for retirement.
Defined Contribution plans are retirement plans that are commonly tied to an employer and allow employees to invest pre-tax dollars into diversified investments.
This way, the employee’s money will grow tax-deferred until they’re ready to retire. Here are the most common types of defined contribution plans:
401(k) - The most common type of retirement plan that’s offered by employers of all sizes.
403(b) - Similar to a 401(k) but offered to employees of public schools and certain tax-exempt organizations
457(b) - Similar to a 401(k) but offered to employees of state and local governments.
Thrift Savings Plan: This plan is a new type of enhanced 401(k) plan that’s available to government workers and members of the uniformed services.
Pros:
Tax advantages: When you open a defined contribution plan, you contribute to the account with pre-tax dollars. This allows your contributions to grow tax-free until they’re ready to be withdrawn. However, you’ll still have to pay taxes upon withdrawal.
Ease: Defined Contribution plans are typically the easiest way to save for retirement as you essentially offload the responsibility of investing onto your employer. Your employer will invest your money for you and can even automatically pull money from your paycheck to invest.
Loan and Hardship Withdrawals: Some plans allow for loans or hardship withdrawals, providing some level of financial flexibility in emergencies (though this can also be a con due to potential penalties and tax implications).
Legal Protections: Funds in these accounts are typically protected from creditors and bankruptcy, offering a level of financial security.
TSP Specific Benefits: For federal employees, the TSP offers low fees and a government match, as well as a variety of investment options tailored to different retirement horizons and risk preferences.
Cons:
No flexibility and control: Your employer typically creates a uniform investment account that it uses for all of its employees. You can control how much money you contribute to your account. But, you may not have a large selection of investment options.
Vesting Schedules: Many employer-sponsored plans have vesting schedules for employer contributions. This means you may not have immediate ownership of the entire employer contribution portion of your account, and if you leave your job before the vesting period is complete, you could forfeit some of those contributions.
Early Withdrawal Penalties: Withdrawing funds from these accounts before reaching the age of 59½ typically results in hefty penalties and tax implications, reducing the amount you receive.
Required Minimum Distributions (RMDs): Once you reach a certain age, you're required to start taking minimum distributions from these accounts, which can have tax implications and may not align with your personal retirement spending needs or strategies.
Taxation at Withdrawal: While contributions to traditional 401(k), 403(b), and 457(b) plans are tax-deferred, distributions in retirement are taxed as ordinary income, which could be a disadvantage if you are in a higher tax bracket in retirement.
How do I open one: There’s a good chance that your employer provided the opportunity to contribute to a defined contribution plan on your behalf when you were hired. To learn more, contact your human resources department.
Contribution limits: In 2024, the contribution limit for 401(k), 403(b), and most 457 plans is $23,000. The catch-up contribution limit for employees aged 50 is $7,500 (so, employees 50 and over can contribute a total of $30,500).
PRO TIP: If you’re still contributing to a retirement account, be sure to check with your employer to see if they offer a match program. Be sure to spread your contribution throughout the year to maximize your matching contributions.
NOTE: Simplified Employee Pension Plans and SIMPLE IRAs are similar types of employer-funded retirement plans. If your employer doesn’t offer a 401(k), be sure to inquire about a SEP IRA or SIMPLE IRA.
Solo 401(k) Plan
Might be best for small business owners with no employees.
Are you interested in opening a 401(k) plan and you're self-employed?
If that’s the case then a solo 401(k) might be a great option for you. A Solo 401(k), also known as an individual 401(k) or a one-participant 401(k), is a retirement savings plan designed specifically for self-employed individuals or small business owners with no employees other than the owner and their spouse.
This plan type is similar in many ways to a standard 401(k) offered by larger employers but has some unique features that make it attractive to solo entrepreneurs.
How do I open one: You can open a Solo 401(k) through most online brokers such as Fidelity or Schwab using your company’s employer identification number (EIN).
Contribution limits: In 2024, the contribution limit for solo 401(k)s is the same as regular 401(k)s, $23,000. But, you can also include a non-elective contribution of up to 25 percent of compensation up to a total annual contribution of $69,000 for businesses.
Individual Retirement Account Plans
After the company-sponsored 401(k) plan, the answer to “what type of account is best for retirement” becomes a bit muddled. The next most common plan to explore for retirement is Individual Retirement Accounts (IRAs). In total, there are four different types of IRA plans that you should be aware of:
Traditional IRA
Roth IRA
Spousal IRA
Rollover IRA
1. Traditional IRA
A Traditional IRA may be the best option for people who have maxed out their 401(k) and are looking for another type of account to open.
Traditional IRAs offer a way to save for retirement that offers tax advantages. Here are two benefits to a traditional IRA:
Tax deductions: Contributions may be fully or partially deductible from your taxes, depending on your filing status and income.
Deferred tax payments: Your earnings and gains are not taxed until you make a withdrawal.
How do I open one: You can open a traditional IRA through most online brokerages.
Contribution limits: The annual contribution limit for 2024 is $7,000, or $8,000 if you're age 50 or older.
2. Roth IRA
A Roth IRA may be the best option for people who have maxed out their 401(k) and are looking for another account to open where you can create tax free income in retirement.
A Roth IRA is very similar to a traditional IRA but varies in the following ways:
You cannot deduct contributions to a Roth IRA from your taxes.
If you satisfy the requirements, qualified distributions are tax-free.
There are no RMDs during the account owner’s lifetime, allowing you to keep the money in the account for as long as you want, which can be advantageous for estate planning.
You can leave your balance in your Roth IRA as long as you live.
How do I open one: You can open a Roth IRA through most online brokerages.
Contribution limits: In 2024, the annual contribution limit is $7,000, or $8,000 if you're age 50 or older.
3. Spousal IRA
A Spousal IRA is best for married couples where one member wants to contribute to a retirement plan on behalf of the other.
A Spousal IRA is a type of Individual Retirement Account (IRA) that allows a working spouse to contribute to an IRA in the name of a non-working spouse. This is an important tool for couples where one spouse may not have earned income, allowing them to still save for retirement in a tax-advantaged account.
These are not joint accounts and the account must be put under one partner’s name.
How do I open one: You can open a Spousal IRA through most online brokerages.
Here are some additional key points about Spousal IRAs:
Eligibility Requirements: To contribute to a Spousal IRA, the couple must be married and file a joint tax return. The working spouse must have enough earned income to cover the contributions to both their own IRA and the Spousal IRA.
Contribution Limits: The contribution limits for a Spousal IRA are the same as a regular IRA. For 2024, the limit is $7,000 per year, or $8,000 if the spouse is age 50 or older. These limits are subject to change, so it's important to stay updated.
Traditional vs. Roth IRA: A Spousal IRA can be either a Traditional IRA or a Roth IRA. The choice depends on factors like the couple's income level, tax situation, and retirement plans. With a Traditional IRA, contributions may be tax-deductible, and earnings grow tax-deferred until withdrawal. With a Roth IRA, contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.
Tax Benefits: The primary benefit of a Spousal IRA is the ability to save for retirement with tax advantages. For a Traditional IRA, you may get immediate tax deductions, while a Roth IRA offers tax-free growth and withdrawals.
Income Phase-Out Ranges: For couples with higher incomes, the ability to deduct Traditional IRA contributions or contribute to a Roth IRA may be limited. These phase-out ranges depend on your modified adjusted gross income and are adjusted annually.
RMDs and Withdrawal Rules: Like other IRAs, Spousal IRAs have rules about Required Minimum Distributions (RMDs) and early withdrawals. For Traditional IRAs, RMDs must start at age 73 or 75 depending upon your age, and early withdrawals may incur penalties. Roth IRAs do not have RMDs, and contributions (but not earnings) can be withdrawn tax-free and penalty-free at any time.
4. Rollover IRA
A Rollover IRA is best for people interested in rolling over a large balance in an employer-sponsored retirement plan to an IRA.
Rollover IRAs are designed to let people rollover funds from an employer-sponsored retirement plan [such as a 401(k)] into a Traditional IRA. This helps maintain the tax-deferred status of those assets and ensures that you won’t have to pay any early withdrawal penalties.
How do I open one: You can open a Spousal IRA through most online brokerages.
Contribution limits: There is no limit on how much you can roll over into an IRA. Rolling money into an IRA also does not impact your annual IRA contribution.
What Type of Account is Best for Retirement? Other Options
In general, Defined Contribution plans and IRAs are the most common ways to fund a retirement. But, that doesn’t mean that they are your only options. Let’s explore a few more non-conventional retirement fund options as we attempt to answer the question: What type of account is best for retirement?
Opening an Individual Brokerage
Depending on your age, opening a standard individual brokerage account can also be an attractive option to help prepare for retirement. An individual brokerage account is an account that allows you to buy a range of assets. The types of assets that you can invest in will depend on your brokerage. But, almost all brokerages will allow you to buy assets like:
Stocks
Bonds
Mutual Funds
ETFs
Cryptocurrency
Pros:
No contribution limits: Brokerage accounts do not have contribution limits which can make them a good option for people who are a bit on retirement savings.
More control: When you open your own brokerage account you can buy whatever assets best suit your investment goals. There are no restrictions or penalties for withdrawing funds at any age, offering more liquidity compared to retirement accounts that typically penalize early withdrawals.
Potential for Capital Gains Tax Rates: Long-term capital gains are typically taxed at a lower rate than ordinary income tax rates, which can be beneficial for investments held for more than a year.
Estate Planning Benefits: Taxable accounts can be easier to transfer to heirs, and they can benefit from a step-up in basis upon the owner's death, potentially reducing the tax burden for heirs.
Cons:
No Tax Advantages on Contributions: Contributions to a taxable account are made with after-tax dollars, and there's no upfront tax deduction like with a traditional retirement account.
Taxes on Investment Gains and Dividends: Unlike retirement accounts, where taxes on gains and dividends are deferred, taxable accounts incur taxes on dividends, interest income, and capital gains in the year they are realized.
Potential for Higher Taxes on Short-Term Gains: Investments sold within a year of purchase are subject to short-term capital gains taxes, which are typically the same as your ordinary income tax rate.
Requires More Active Management: Managing a taxable account often requires more active involvement and understanding of tax implications, especially when it comes to buying and selling assets.
Can Impact Financial Aid Eligibility: Funds in a taxable account may be counted as assets for financial aid calculations for college, potentially reducing eligibility for aid.
Vulnerability to Creditors: In contrast to retirement accounts, which often have protections from creditors, taxable accounts generally do not offer such protections.
How do I open one: You can open a brokerage account through most major financial institutions.
In addition to retirement accounts, you can also use different types of insurance products to help fund your retirement. For example:
Guaranteed Income Annuities (GIAs): This is a contract between you and an insurance company where they promise to pay you income on a regular basis for the rest of your life.
Cash Value Life Insurance: This is a type of permanent life insurance that includes an investment feature. The cash value of your policy can grow over time and may be available to withdraw or borrow against.
Final Thoughts: What Type of Account Is Best for Retirement?
In general, the most conventional way to fund a retirement is to contribute to a 401(k) account through your employer. Once you have maxed out your contribution limit, you can explore an IRA to help pad your retirement portfolio. But, it’s important to remember that there is no one-size-fits-all approach to retirement.
Retirement planning is a complex process that depends on many different factors, such as:
Income level and tax bracket
Employment status and plans that your employer offers
Future financial goals
Lifestyle expectations in retirement
Desired retirement age and timeline
Risk tolerance and investment strategy
The highly personal nature of retirement planning is why it’s so critical to work closely with a professional. If you want to figure out which retirement account is best for you, be sure to take our free retirement assessment.
We hope that you’ve found this article valuable when it comes to learning what types of retirement account is best for retirement. If you’re interested in reading more, please subscribe below to get alerted of new articles as we write them.
Or, if you have over $1 million in savings and investments, be sure to conduct our free retirement assessment to find the strategy that works best for you.
Author: Mark Fonville, CFP®
Mark is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors specializing in helping individuals aged 50 plus plan, invest, and enjoy retirement without the stress of money.
Forbes nominated Mark as a Best-In-State Wealth Advisor* and he has been featured in the New York Times, Barron's, Forbes, and Kiplinger Magazine.
Disclosure: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.
Registration of an investment advisor does not imply a certain level of skill or training.