There’s no question that saving for retirement is one of the most important — and most ambitious — facets of your financial plan. And the earlier you start, the better off you will be, as you benefit from tax advantages and compounding growth.
But one of the biggest barriers to saving for retirement is simply a lack of information and education about the different types of retirement plans. Trying to figure out where and how to save can turn into a confusing, heaping bowl of alphabet soup — 401k, 403b, IRA, TSP, HSA, and on and on.
The good news is, these accounts really aren’t all that complicated. And it’s not important to understand the differences between all of them — just the ones for which you qualify. With a little bit of guidance and information, you’ll be well on your way to deciding which plans make the most sense for you.
What is a retirement plan?
Retirement savings accounts are different from most other savings vehicles, like banking accounts or other investment accounts (i.e. brokerage accounts). The biggest benefit of retirement accounts are their tax advantages. While the specific tax treatments differ between various retirement plans (more on those specific details later), they all come with some form of unique tax advantage when compared to non-retirement accounts as an incentive for people to save for retirement.
At the end of the day, understanding the differences between the various types of retirement accounts comes down to a few main factors:
- Eligibility
- Tax benefits
- Investment options
- Annual contribution limits
- Withdrawal penalties
- Required minimum distributions (RMDs)
Main categories of retirement accounts
Before jumping into the specific types of retirement accounts, it’s important to understand the broad categories of retirement plans and the differences between them.
Employer-sponsored vs. individual retirement accounts
Employer-sponsored retirement accounts
Employer-sponsored retirement accounts are what most people think of when they think of saving for retirement. Examples include 401(k), 403(b), 457(b), TSP, SIMPLE IRA, and others. Essentially, employer-sponsored plans are retirement accounts offered by employers to their employees. In order to gain access to one of these plans, you must be employed by an organization that administers the plan, and you must meet their eligibility requirements. If you participate, you will select a portion of each paycheck to directly contribute to your retirement account.
Access to employer plans are conditional upon your employment and specific eligibility criteria set by the employer. One benefit of many employer sponsored plans is that they offer an employer match. For example, an employer may make a matching contribution to an employee’s 401(k) up to a certain percentage of their compensation. For the account holder, this essentially adds up to free money. Pay careful attention to your plan’s vesting schedule, however. That is, the amount of time you have to work at an organization in order to be guaranteed the full value of your employer’s matching contributions.
Individual retirement accounts
Unlike employer sponsored plans, individual retirement accounts are in no way connected to, or reliant upon, your employment. As long as you meet the basic eligibility requirements for the specific account type, you can establish an individual retirement account regardless of where you work.
Defined contribution vs. defined benefit retirement plans
Defined contribution plans
The Employee Retirement Income Security Act (ERISA) outlines two types of retirement plans: defined contribution and defined benefit. With defined contribution plans, you and/or your employer contribute to your retirement account, typically at a set (or defined) rate (i.e. a percentage of your earnings). These contributions are then invested in a retirement account, and the balance of your account is the amount of your retirement savings. Defined contribution plans are the most common type of retirement plans today. Essentially, the balance of your retirement savings is equal to what you put in and what your employer(s) put in, plus or minus investment gains or losses.
Defined benefit plans
Unlike defined contribution plans, savings in defined benefit plans are not invested in your individual account. Instead, defined benefit plans offer a set monthly benefit in retirement. Usually, your specified benefit will be calculated based on your salary and years of service. Pension plans are a common example of a defined benefit plan.
So, with defined contribution plans, you will accumulate a balance in your individual retirement account that is based on the specific amount you contribute from your earnings (plus or minus investment gains or losses). In retirement, you will have control over the amount of your monthly distributions from your account, and those distributions may vary over time based on your specific needs.
With defined benefit plans, on the other hand, your monthly benefit is specified. It is not based on the exact amount you contribute from your earnings or investment performance.
Traditional vs. Roth retirement accounts
Traditional retirement accounts
The primary difference between traditional and Roth retirement plans is the tax treatment. Specifically, they differ on when taxes are paid.
With traditional retirement accounts, the tax benefits are immediate. Contributions to traditional retirement accounts are considered tax deductions. There are some exceptions for high income-earners (the deduction is subject to an income phaseout), but for most people, contributions to traditional retirement accounts are considered pre-tax. As a result, you will defer paying taxes on these contributions. You won’t have to pay taxes on this money until you withdraw the funds from your retirement account.
Roth retirement accounts
Unlike traditional accounts, the tax benefits for Roth accounts are not immediate. The advantage to Roth accounts is that you will not pay tax on your distributions. Instead, you will pay taxes on your earnings before investing them in your retirement account. This is what is known as a post-tax contribution.
When deciding between a traditional or Roth retirement account, you’ll have to do a bit of forecasting. Regardless of when you pay taxes (pre-tax with traditional or post-tax with Roth), the amount you pay will be based on your tax bracket at the time those taxes come due. And your tax bracket is based on your taxable income.
You’ll need to do an analysis and decide if you expect your income to be higher or lower now vs. in retirement. If you expect to be in a higher tax bracket in retirement, then you’ll pay less total taxes by contributing to a Roth account (and paying those taxes now) vs. deferring those taxes. If, on the other hand, you expect to be in a lower tax bracket when you’re in retirement, you’ll want to contribute to a traditional retirement account and defer paying taxes now.
Comparing types of retirement accounts
Let’s compare some retirement accounts based on some key factors (eligibility, contribution limits, etc.) and special considerations. We’ll take a look at some of the most common accounts, differentiated by individual accounts, employer-sponsored accounts, and accounts that are best suited for self-employed people and small business owners.
Individual retirement accounts
- Traditional IRA
- Roth IRA
Employer sponsored retirement plans
- Traditional and Roth 401(k)
- 403(b)
- 457(b)
- Thrift Savings Plan (TSP)
Retirement accounts for self-employed and small business owners
- SEP IRA
- SIMPLE IRA
- Solo 401(k)
Traditional IRA
Eligibility
Anyone with earned taxable income is eligible for a traditional IRA. Since they are not employer-sponsored plans, your traditional IRA will not be conditioned upon or connected to your employer.
Tax benefits
Contributions to traditional IRAs are made on a pre-tax basis, and the growth is tax-deferred. That means you won’t pay taxes on your IRA contributions until the savings are withdrawn in retirement. However, you cannot deduct traditional IRA contributions if you’re eligible for an employer sponsored retirement plan and earn more than $78,000 per year.
Investment options
Unlike 401(k) plans and most common employer-sponsored accounts, traditional IRAs offer a wide range of investment options.
Contribution limits
One of the downsides to IRAs, relative to employer-sponsored plans, is their low contribution limits. In 2022, the contribution limit for a traditional IRA is $6,000 for people younger than 50, or $7,000 if you are 50 or older.
Withdrawal penalties
For traditional IRAs, there’s typically a 10% early withdrawal penalty for withdrawing funds before age 59.5.
Required minimum distributions (RMDs)
You are required to start making withdrawals from your traditional IRA at age 72. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
IRA accounts carry much more investment options and lower account fees than the typical employer-sponsored plan.
In some cases, you may be able to contribute to your IRA and an employer-sponsored plan — furthering your retirement goals and tax advantages.
Who’s it best for?
IRAs make sense for most people, and they are one of the top choices for people who have already contributed enough to their employer sponsored plan to receive their employer’s matching contribution (or for people who simply don’t have access to an employer sponsored plan). IRAs are also an excellent vehicle for rolling over funds from inactive 401(k)s or other employer sponsored accounts once you separate from that organization. Whether you choose a Roth or traditional IRA will depend on your current income and forecasted income in retirement.
Roth IRA
Eligibility
Similar to a traditional IRA, Roth IRAs are individual accounts that are not linked to your employer. As long as you have taxable income, you can establish a Roth IRA; however, you can only actively contribute to a Roth IRA if your income is below a specific threshold. Earners with more than $144,000 in taxable income per year (or $214,000 if married filing jointly) are not eligible to make Roth IRA contributions.
Tax benefits
With Roth IRAs, you pay taxes on your contributions, meaning those contributions are made on a post-tax basis. The benefit is that your savings grow tax-free. When you withdraw the money in retirement, you will not owe any additional taxes, assuming you’re at least 59.5 in age. Based on your tax bracket, this could mean you’ll pay less taxes overall.
Investment options
As is the case with traditional IRAs, Roth IRAs offer a wide variety of investment choices, especially when compared to more restrictive employer sponsored plans.
Contribution limits
Roth IRAs have relatively low contribution limits. In 2022, the contribution limit for a traditional IRA is $6,000 for people younger than 50, or $7,000 if you are 50 or older. It’s important to know that these contribution limits encompass both traditional and Roth IRAs, meaning that your total annual contributions to traditional and Roth IRAs cannot exceed $6,000 (or $7,000 for people 50 and over).
Withdrawal penalties
You can withdraw contributions from a Roth IRA with no early withdrawal penalty. Although you can withdraw any direct contributions at any time, they are not replaceable (i.e., you’re still limited to $6,000-$7,000 of total contributions each year for all IRAs). To avoid paying a 10% penalty on your earnings (that is, the capital gains), you must wait until age 59.5.
The IRS does have some exceptions, which allow you to withdraw both contributions and earnings before age 59.5 penalty free. Some of those exceptions include a first-time home purchase, adoption expenses, or college tuition. For these reasons, the Roth IRA is often considered the most flexible and tax-advantageous retirement account available, particularly for those who expect to be in a higher tax bracket in retirement.
Required minimum distributions (RMDs)
There are no required minimum distributions for Roth IRAs.
Special considerations
The main consideration for a Roth IRA is the tax advantage. With Roth IRAs, withdrawals and earnings are tax-free. An additional benefit if that you can withdraw funds from a Roth IRA before retirement without penalty.
Although there are income restrictions for contributing to a Roth IRA, one special consideration is a “backdoor” Roth contribution or a Roth conversion. With some time, effort, and know-how, you may be able to convert a traditional IRA into a Roth. While this may result in some immediate tax burden (remember, Roth IRA contributions are post-tax), the end result will be long-term tax-free growth and withdrawals in retirement.
Lastly, because a Roth IRA does not have any early withdrawal penalties on contributions, it can act as an emergency fund if you are really in a pinch, and as a good wealth-transfer vehicle.
Who’s it best for?
Roth IRAs are best for people who want to take advantage of tax-free withdrawals and growth in retirement. Because of the great tax advantages, we almost always recommend young professionals maximize their annual Roth contributions when they are eligible and able. Roth conversions also often make sense for retirees in their early years. Lastly, “backdoor” Roth conversions often make sense for high-income earners throughout their earning (or wealth accumulation) years.
401(k)
Eligibility
401(k)s are employer-sponsored retirement plans. That means eligibility is conditional based upon your employment and specific criteria outlined by your employer. The specific details of 401(k) plans vary from employer to employer, and the employer designates who qualifies.
Tax benefits
Some organizations offer both a pre-tax (i.e., traditional) and a post-tax (i.e., Roth) 401(k). With a traditional 401(k), your tax benefit will be immediate, and contributions will reduce your taxable income. All contributions are made and will grow tax free. You will not owe any taxes until you start taking distributions from your retirement account.
With a Roth 401(k), you will pay taxes on the contributions immediately, but the contributions will grow tax free, and you won’t owe any taxes when you withdraw the money in retirement. Once you have separation of service with your employer, you can also rollover this money into a Roth IRA.
Investment options
One of the biggest downsides to 401(k) plans (as compared to an IRA) is that they offer limited investment options. You won’t have access to the full portfolio of investment funds and options in the market. Instead, you’ll only be able to choose from a limited number of funds offered with your employer’s plan. A small number of 401(k)s have a brokerage window, allowing for an increased number of investment choices.
Contribution limits
Compared to many retirement accounts, 401(k) plans have high contribution limits. In 2022, you can contribute up to $20,500 to a 401(k) plan, or $27,000 if you’re 50 or older.
Withdrawal rules
In most cases, you must be at least 59.5 to withdraw funds from your 401(k) to avoid early withdrawal penalties. If you withdraw money before age 59.5, you may be subject to a 10% penalty.
Required minimum distributions (RMDs)
You are required to start withdrawing a specified amount of money from your 401(k) at age 72, unless you are still working for the employer that holds your 401(k). The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy, as defined by the IRS.
Special considerations
One unique aspect of many employer sponsored plans, including 401(k) plans, is the possibility for an employer match. Many employers will offer a matching contribution, oftentimes up to a certain percentage of an employee’s salary. Let’s say for example your employer offers a 4% matching contribution. If your salary is $100,000 and you contribute 4% to your 401(k) ($4,000), your employer will contribute an additional $4,000. Employer matches essentially add up to free money in your retirement savings account. You do need to make sure you know your plan’s vesting schedule. It could take multiple years before you own 100% of your employer’s contributions.
Accounting for both employee and employer contributions, the total annual additions limit for employer sponsored plans is $61,000 in 2022 (or $67,500 for people who are 50 and older).
A downside to 401(k)s is that they typically have high administrative account fees, and your ability to contribute to your 401(k) is contingent upon your employment and criteria outlined by your employer. That means that if you separate from your employer, you’ll typically still have access to your 401(k) plan, but you won’t be able to make additional contributions. To avoid continuing to pay those high administrative account fees, as well as to have access to a larger pool of better investments, we usually recommend and help our clients roll their 401(k) savings over to an IRA.
Who’s it best for?
401(k) plans are best for active employees who are eligible for their employer’s 401(k) plan, especially if their employer offers a matching contribution (again, that’s basically free money).
403(b)
Eligibility
403(b) plans are usually offered to employees of non-profit organizations, including public schools and churches. Like 401(k) plans, 403(b) plans are employer sponsored retirement accounts. That means they are only available to people whose employers offer a 403(b) plan and meet the criteria specified by the employer for participation.
Tax benefits
Similar to a 401(k) plan, contributions to a 403(b) are made on a pre-tax basis, and your savings grow tax-deferred. You will pay tax on the money when you withdraw it in retirement.
Investment options
403(b) plans have limited investment options. They are typically even more restrictive than 401(k) plans.
Contribution limits
In 2022, the contribution limit for 403(b) plans is $20,500. If you are 50 or older, you can contribute up to $27,500. An additional benefit of a 403(b) is that employees who have at least 15 years of service with the employer can make bonus catch-up contributions of $3,000 per year up to a lifetime maximum of $15,000 in catch-up contributions.
Withdrawal penalties
In most cases, you must be at least 59.5 to withdraw 403(b) contributions and earnings to avoid early withdrawal penalties. If you withdraw money before age 59.5, you may be subject to a 10% penalty.
Required minimum distributions (RMDs)
You are required to start withdrawing a specified amount of money from your 403(b) at age 72, unless you are still working for the employer that holds your 403(b). The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
Like 401(k) plans, 403(b) plans sometimes offer an employer matching contribution, which can add free money to your retirement savings. Additionally, 403(b) plans typically carry high administrative fees relative to individual retirement accounts. For that reason, if you have an active 403(b) and separate from your employer, you may want to consider rolling your savings into an IRA. The primary difference between a 401(k) and 403(b) is the 15-year bonus catch-up contributions ($3,000 per year, up to $15,000 lifetime). Both plans may offer a Roth (i.e., post-tax contribution) option, allowing account holders to avoid taxes when withdrawing both contributions and gains in retirement.
Who’s it best for?
403(b) plans are best for active employees who are eligible for their employer’s 403(b) plan, especially if their employer offers a matching contribution (again, that’s basically free money).
457(b)
Eligibility
457(b) plans are usually limited to employees of local, state, and federal government agencies. 457(b) plans are employer sponsored retirement accounts that are only available to people whose employers offer a 457(b) plan and meet the criteria specified by the employer for participation.
Tax benefits
Contributions to a 457(b) are made on a pre-tax basis, and your savings grow tax-deferred. You will pay tax on the money when you withdraw it in retirement.
Some 457(b) plans do allow for Roth accounts. Like Roth 401(k) plans, contributions to a Roth 457(b) are made on a post-tax basis and grow tax-free; however, you will not pay taxes on withdrawals in retirement.
Contribution limits
In 2022, the contribution limit for 457(b) plans is $20,500 per year. If you are 50 or older, you can contribute up to $27,500. An additional benefit of a 457(b) is that employees can contribute up to double the annual limit in each of the three years before retirement.
Withdrawal penalties
457(b) plan participants can withdraw money from their 457(b) as soon as they retire, regardless of age. With 401(k) and 403(b) plans, retirees must wait until at least age 59.5 to avoid early withdrawal penalties.
Required minimum distributions (RMDs)
You are required to start withdrawing a specified amount of money from your 457(b) at age 72, unless you are still working for the employer that holds your 457(b) plan. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
In some cases, employers may offer a 457(b) plan in addition to a 401(k) or 403(b). When this happens, employees may be able to contribute to both and take advantage of greater tax benefits.
One downside to 457(b) plans is that they do not have the same kind of employer matching contribution option as 401(k) and 403(b) plans. Employers can still make contributions, but they count toward the individual contribution limit.
Who’s it best for?
457(b) plans are best for eligible employees of local, state, and federal government agencies, particularly those who do not have the option to contribute to a 401(k) or 403(b) — and those who expect to retire before age 59.5. Because of the various advantages, we recommend many of our university clients save to all three retirement plans available to them — the 457(b), 403(b), and the 401(a) plan (often referred to as the Optional Retirement Plan or ORP).
Thrift Savings Plan (TSP)
Eligibility
TSP plans are employer sponsored retirement accounts available only to eligible federal employees and military personnel.
Tax benefits
TSPs can be Roth or traditional. Traditional TSP contributions are made on a pre-tax basis, and your savings grow tax-deferred. You will pay tax on the money when you withdraw it in retirement. Roth TSP contributions are made on a post-tax basis and grow tax-free, and you will not pay taxes on withdrawals in retirement.
Investment options
TSPs offer limited, but low-cost, investment options.
Contribution limits
In 2022, the contribution limit for TSPs is $20,500 per year. If you are 50 or older, you can contribute up to $27,500.
Withdrawal penalties
In most cases, you must be at least 59.5 to withdraw TSP contributions and earnings to avoid early withdrawal penalties. If you withdraw money before age 59.5, you may be subject to a 10% penalty.
Required minimum distributions (RMDs)
You are required to start withdrawing a specified amount of money from your TSP at age 72, unless you are still working for the employer that holds your TSP plan. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
TSP plans have some of the most limited investment options of all retirement accounts. That said, the investment options and accounts are typically low-cost relative to other accounts.
Another unique aspect of TSP plans is that employees receive employer contributions even if they (the employees) don’t contribute.
TSP plans typically have at least a three-year vesting period for some employer contributions.
Who’s it best for?
Thrift Savings Plans are best for eligible federal employees and military personnel. They are particularly good because of the non-elective employer contributions.
SEP IRA
Eligibility
SEP IRAs (or simplified employee pensions) are employer sponsored plans that are primarily used by self-employed people and small business owners. If a small business owner establishes a SEP IRA, they must offer participation to all employees who are 21 or older, earn at least $600 per year, and have worked at the company for three out of the last five years.
Tax benefits
For the account holder, contributions are made on a pre-tax basis. The savings will grow tax-deferred. Account holders will pay taxes on withdrawals in retirement.
For the employer, SEP IRA contributions are tax-deductible business expenses.
Investment options
Like other types of IRAs, SEP IRAs offer a wide range of investment options and relatively low plan costs.
Contribution limits
One key advantage to SEP IRAs is that they have higher contribution limits than traditional or Roth IRAs. However, a key distinction is that with SEP IRAs, only the employer can make contributions to an employee’s SEP IRA. In 2022, employers can contribute up to 25% of an employee’s compensation or $61,000 (whichever is less) to an employee’s SEP IRA.
Withdrawal penalties
In most cases, you must be at least 59.5 to withdraw SEP IRA contributions and earnings to avoid early withdrawal penalties. If you withdraw money before age 59.5, you may be subject to a 10% penalty.
Required minimum distributions (RMDs)
You are required to start making withdrawals from your SEP IRA at age 72. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
For small business owners, SEP IRAs can be much less expensive and much simpler than other retirement accounts. However, SEP IRAs do require that employers contribute the same percentage of their employees’ income to their accounts as they do to their own — and vesting is immediate. Because these plans are employer contribution only, employees’ retirement savings will rely heavily on the success of the business.
For employees, SEP IRAs have the advantage of vesting immediately. That means your employer’s contributions are 100% yours as soon as they are made to your account.
Who’s it best for?
SEP IRAs are best for self-employed people and small business owners who want to contribute to IRAs for all of their employees.
SIMPLE IRA
Eligibility
SIMPLE IRAs (Savings Incentive Match Plan for Employees) are employer sponsored retirement plans for small businesses with 100 or fewer employees. Eligibility is contingent upon employment and an employer’s specific eligibility criteria. Typically, employees must have earned $5,000 in any two previous years and be expected to earn at least $5,000 in the current year to qualify.
Tax benefits
SIMPLE IRA contributions are made on a pre-tax basis. The savings will grow tax-deferred. Account holders will pay taxes on withdrawals in retirement.
For the employer, SIMPLE IRA contributions are tax-deductible business expenses.
Investment options
Like other types of IRAs, SIMPLE IRAs offer a wide range of investment options and relatively low plan costs.
Contribution limits
In 2022, SIMPLE IRA participants can contribute up to $14,000 from their salary, or $17,000 if they are 50 or older.
Employers that offer a SIMPLE IRA typically match employee contributions up to 3%. In some cases, they may contribute 2% of an employee’s salary, regardless of the employee’s contribution. For employees, SIMPLE IRA contributions are immediately fully vested.
Withdrawal penalties
There is a 25% early withdrawal penalty on distributions made before age 59.5.
Required minimum distributions (RMDs)
You are required to start making withdrawals from your SIMPLE IRA at age 72. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
For employers, SIMPLE IRAs are easy to set up, relative to other employer sponsored retirement plans. That said, they’re only available to organizations with fewer than 100 employees. Additionally, the contribution limits are lower than with a 401(k), and there are relatively high early withdrawal penalties (25% before age 59.5).
Who’s it best for?
SIMPLE IRAs are an inexpensive employer sponsored retirement plan option for organizations with fewer than 100 employees.
Solo 401(k)
Eligibility
Solo 401(k)s are intended for self-employed individuals with no employees (other than their spouse).
Tax benefits
For solo 401(k)s the tax benefits are two-fold for the self-employed entrepreneur. On the business side, the employer contributions are tax-deductible.
As the employee, solo 401(k) contributions can either be Roth or traditional. With Roth solo 401(k)s, contributions are made on a post-tax basis. The savings will grow tax-free, and you won’t have to pay taxes on withdrawals in retirement. For traditional solo 401(k)s, contributions are made on a pre-tax basis. The savings will grow tax-deferred, but account holders will pay taxes on withdrawals in retirement.
Investment options
Like most 401(k) plans, solo 401(k) accounts typically have more limited investment options compared to IRAs.
Contribution limits
For self-employed people, a solo 401(k) is unique in that it allows them to make contributions to their retirement savings account both as the employer and the employee.
On the employee side, you can contribute up to $20,500 to your solo 401(k) account in 2022 (or $27,000 if you are 50 or older). As the employer, you can contribute up to an additional 25% of your compensation. The total contribution (employee’s individual contribution plus the employer’s contribution) cannot exceed $61,000 (or $67,500 if you are 50 or older).
Withdrawal penalties
In most cases, you must be at least 59.5 to withdraw funds from your solo 401(k) to avoid early withdrawal penalties. If you withdraw money before age 59.5, you may be subject to a 10% penalty.
Required minimum distributions (RMDs)
You are required to start making withdrawals from your solo 401(k) at age 72. The specific amount you are required to withdraw is based on the balance of your retirement account and your life expectancy.
Special considerations
Although you cannot open a solo 401(k) if you have employees, self-employed people can establish a solo 401(k) plan for both themselves and their spouse. They can also make employer contributions for both the business owner and their spouse.
Who’s it best for
Solo 401(k) plans are best for self-employed people with no employees who have enough income and business revenue to fully fund their account.
Bonus: Health Savings Account (HSA)
Although not necessarily considered a retirement account, a Health Savings Account can be used as an incredible tax-savings vehicle in a retirement plan. Contributions to HSAs can be invested similarly to 401(k)s and IRAs.
The main differentiator is that — if used strategically — the money in your HSA may never be taxable. That is, the contributions are made on a pre-tax basis, the funds grow tax-free, and you also won’t pay taxes on the withdrawals. This only applies if the funds are used to pay for qualified medical expenses. So, while the money won’t be tax-free for any expense, you can count on these triple-tax-advantaged savings to help supplement Medicare instead of pulling from your other retirement accounts to pay for medical expenses in retirement.
Non-eligible (i.e., non-medical) distributions can be taken when you are 65 years old or older without any penalty, but you would have to pay taxes (similar to distributions from a traditional IRA).
To be eligible for an HSA, you must be enrolled in a high-deductible health insurance plan. There are contribution limits, as well. In 2022, individuals with self-only health insurance plans can contribute up to $3,650. Those with family health insurance plans can contribute up to $7,300. There is also an annual catch-up contribution of $1,000 per year for people age 55 or older. Up to the annual limit, contributions are 100% deductible regardless of whether you itemize your taxes.
How to prioritize retirement accounts for savings
When it’s not possible to maximize all of your eligible retirement accounts, you’ll need to be more selective (and more strategic) about where to allocate limited savings. While our specific advice will vary depending on a person’s unique financial situation, our general recommendation would be to prioritize retirement accounts in the following order:
- Maximize your employer’s matching contribution. If your employer offers a matching contribution up to a certain percentage of your compensation, make sure you are contributing at least that much to your employer sponsored plan. The employer match is free money, and you shouldn’t leave any free money on the table.
- Maximize your Roth IRA contributions. There is a reason why there’s an income limit for Roth IRAs, and it’s because they offer serious tax benefits. Unlike a traditional IRA, you’ll never pay taxes on the growth of your investments in a Roth IRA. Given the historic performance of the stock market, that could lead to big long-term savings.
- Maximize your HSA contributions. If you’re eligible for an HSA, then you have access to one of the most tax-advantaged accounts out there. Some employers even offer a matching amount on your contributions. If you use savings from your HSA on healthcare expenses, you’ll never pay taxes on the contributions or the growth. And worst case scenario, if you do have to use the funds on a non-qualified expense, you’ll just be required to pay taxes on the withdrawal (similar to a traditional IRA or 401(k)).
- Maximize your traditional IRA contributions. If you’re ineligible to contribute to a Roth IRA, focus on maximizing your traditional IRA instead. IRAs still offer more investment choices than most employer sponsored retirement plans, and you have greater control. Plus, they belong fully to you and aren’t connected to your employer. It’s great to have a traditional IRA established in the event you need to roll over or consolidate employer sponsored accounts from previous jobs.
- Maximize your employer sponsored retirement account. Once you’ve met your employer’s match, maximized your HSA, and maximized your Roth or traditional IRA, focus on maxing out your employer sponsored retirement account. The growth potential is much greater than sticking money in a banking account, and the tax advantages are greater than a typical brokerage account.
Conclusion: Which retirement account is best for me?
Although there are a lot of different types of retirement accounts (we didn’t even cover them all here!), the specific options available to you are likely pretty limited. You usually won’t have access to all of the employer sponsored accounts listed here. The ones you do have access to will be determined by your specific employer.
As financial advisors, it’s important for us to know the differences between various retirement accounts. But for many consumers, the most important thing is to understand the nuances between the accounts you’re actually eligible for.
Under typical circumstances, you will be in great shape if you begin saving for retirement as soon as you’re eligible and focus on maximizing your employer’s matching contributions in your employer sponsored retirement account plus saving diligently to an IRA.
If you need help determining which accounts you’re eligible for, which ones to prioritize, or how much you should be saving for retirement, our team is here to offer you unbiased advice. Personalized retirement planning and investment management are key elements of our comprehensive financial planning process. You can book a discovery call today to learn more about our services and how we could help bring value to your complete financial well-being.
