Table of Contents
Table of Contents
- Employer-sponsored plans, such as 401(k)s and 403(b)s, have many benefits like pre-tax contributions, tax-deferred growth, and potential employer matching, making them a crucial part of retirement savings for many workers.
- Employer plans have limitations such as early withdrawal penalties, contribution limits, and limited investment choices, which may not meet the needs of all investors.
- Traditional individual retirement accounts (IRAs) offer more flexibility, investment choices, and tax advantages, but have lower contribution limits compared to employer plans.
- Health savings accounts (HSAs) provide a triple tax advantage for qualified medical expenses and can be used as a retirement savings tool, but are only available to individuals with high-deductible health plans.
- Fully taxable investment accounts offer flexibility and a broader range of investment options but lack the tax advantages and contribution limits of retirement accounts.
Workplace retirement accounts are often considered the go-to choice for employees looking to build their financial cushion. There's a good reason for that: Employer plans such as 401(k)s offer unique tax advantages and other benefits that often put them among the top of the class when it comes to retirement planning options.
However, investing outside of your employer's plan sometimes can benefit your individual situation even more. Here's a look at how to help ensure you're saving enough for retirement as well as alternative options you might want to consider.
When May an Employer Plan Not Be the Best Option?
Defined contribution plans, such as a 401(k), can be a tremendous way for employees to accumulate the assets needed for retirement. These popular accounts have many benefits:
- Contributions can be made through payroll deduction.
- Traditional 401(k) contributions are made with pre-tax dollars, increasing your purchasing power.
- They offer tax-deferred growth, meaning you don't pay tax on your investment gains, if any, until you make withdrawals in retirement.
- Many employers will match a portion of your contribution.
It's no wonder workplace plans are part of the bedrock of retirement savings in the U.S. About 72.2 million workers actively contribute to a 401(k) plan at work, and millions of former employees and retirees continue to maintain balances in them.1 Additionally, many employees at public schools and other tax-exempt organizations participate in 403(b) retirement plans, which are similar to the more well-known 401(k)s.2
However, workplace plans aren't perfect for every investor. For one, they don't offer a tremendous amount of flexibility if you need to pull out funds early. With 401(k)-style plans, you ordinarily can't take a distribution from your account before age 59½. If you do, you'll typically face a 10% penalty on the amount of your withdrawal in addition to the income tax owed.3
Some employer plans allow you to avoid that early withdrawal penalty and income tax hit by taking out a loan. Usually, you can borrow up to $50,000 or half your vested account balance, whichever is less. However, you often have to pay back your account, with interest, within five years or face a penalty. Plus, you'd be replenishing your account with after-tax money, so you'd lose the tax benefit these accounts offer.
Restrictions Related to 401(k)s
Workplace plans also come with contribution limits. For 2024, employees younger than 50 can put up to $23,000 into a 401(k) or 403(b). If you're 50 or older, you can contribute an additional $7,500 per year through the catch-up provision.4 While that cap isn't a problem for a lot of workers, higher wage earners and aggressive savers eventually find they have to invest their money elsewhere.
Then there's the issue of investment choice. When investing in a 401(k), individuals are often limited to the mutual funds, target date funds or stable value funds offered by the plan. According to FINRA, which regulates securities dealers, the average workplace plan offers eight to 12 choices.5 If you want to invest in individual stocks or prefer a broader array of fund options, you'll need a separate savings vehicle.
What to Know About IRA Options
If you're looking to invest outside of your workplace plan, a traditional individual retirement account (IRA) is a popular choice. These accounts offer some of the same perks as a traditional 401(k)-style plan. Namely, your earnings can be tax-deferred until retirement, and you can claim a deduction on your contributions if you fall within income limits (in part, those thresholds depend on whether you have access to a workplace plan).6
There's also a lot more choice. Whereas workplace plans generally limit you to a dozen or so funds, many IRAs offer a wide range of mutual funds, stocks, bonds and other securities. Plus, your account is independent of your employer, so you have more control over when and how you fund it.
Perhaps the biggest drawback of IRAs, however, is their lower contribution limit. You can only invest up to $7,000 a year with an IRA if you're younger than 50, or up to $8,000 if you're 50 or older.4 A lot of workers won't be able to rely on one of these accounts as their sole investment vehicle.
Supplementing a Workplace Plan With an IRA
So when does choosing an IRA make sense, even if you have a workplace plan? Investing outside your 401(k) or 403(b) might be a good alternative if your employer doesn't offer a contribution match or you're already contributing enough to the company plan to maximize the match. In either of those scenarios, you might be looking for a tax-advantaged account with greater investment choice, lower fund fees or more flexibility overall. IRAs often fit that bill.
There's another factor that can make IRAs a good choice, too: tax diversification. If your employer only allows you to invest with pre-tax dollars, you can achieve diversification by putting some of your savings into a Roth IRA. Unlike traditional retirement accounts, you contribute after-tax dollars to a Roth IRA and can withdraw the funds without paying income tax on them and without incurring penalties after age 59 and a half (if you've also owned the account for at least five years). So contributing to a Roth IRA — provided that you fall within the income limits — can lower your taxable income in retirement.6 Keep in mind that doing so may not be a good idea unless you've already topped off the match on your employer plan.
The Role HSAs Can Play
Health savings accounts might seem like an odd way to save for retirement, but they can play an important role for many workers. Why? Because HSAs offer something that 401(k)s and IRAs don't — a triple tax advantage.
With HSAs, you contribute with pre-tax money. Earnings you accrue are tax-deferred while they're in your account, and withdrawals don't incur income tax when spent on qualifying medical purchases.7 That includes everything from doctor visits and physical therapy to lab fees and assisted living expenses.8 And while most health insurance premiums may not fit the bill, long-term care insurance and Medicare coverage for those 65 and older are qualified expenses.9
Unfortunately, HSAs aren't available to everyone. You must have a high-deductible health plan to contribute. But if you're eligible, their tax benefits are hard to beat. Some HSA providers offer investment options, so it might make sense to allocate a part of your retirement savings to one of these accounts as long as you're already receiving the full match on your workplace plan.
Covering Current and Future Health Care Costs
Why divert your retirement money to an account focused on health care needs? If you're like most people, someday you'll probably spend a large sum on medical expenditures anyway. According to research by Fidelity, the average couple will need roughly $315,000 in after-tax funds to cover health costs in retirement.10
If you end up saving more than you use on health needs, you're still in good shape. Those who withdraw money for nonmedical expenses after age 65 have to pay ordinary income tax on withdrawals but won't face an additional penalty.8 In the meantime, you can benefit from tax-deductible contributions and tax-deferred growth.
For 2024, the IRS allows you to contribute up to $4,150 if you have a high-deductible health plan that covers only you and up to $8,300 if your plan provides family coverage.9 Using these accounts strategically can help ensure you're saving enough for retirement.
Other Taxable Accounts That Might Work for You
For obvious reasons, fully taxable investment accounts — whether with a brokerage, mutual fund provider or insurance company — may not be the first choice among your retirement planning options. But if, for example, you run up against your 401(k) and IRA contribution limits, you might need a way to invest additional dollars without those caps in your way.
If there's one area where nonqualified investment accounts shine, it's flexibility. Instead of being confined to a relatively small menu of choices, you'll generally have access to a wider range of funds; brokerage accounts let you delve into individual stocks and bonds. Plus, you can pull your money out at any time without paying an early withdrawal fee. And a lower tax rate may apply to your gain (if any) than the tax rate that applies to your ordinary income.
It's true that you have to pay applicable fees on any earnings you accrue, but you can potentially minimize your tax burden by focusing on tax-efficient investments like exchange-traded funds. These products tend to buy and sell shares less frequently than actively traded funds, generating fewer taxable gains.
- Workplace Retirement Plans: By the Numbers. https://www.ici.org/faqs/faq/401k/faqs_401k.
- Retirement plans FAQs regarding 403(b) tax-sheltered annuity plans. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-403b-tax-sheltered-annuity-plans.
- Hardships, early withdrawals and loans. https://www.irs.gov/retirement-plans/hardships-early-withdrawals-and-loans.
- Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
- Retirement Accounts. https://www.finra.org/investors/investing/investment-accounts/retirement-accounts.
- Retirement Topics - IRA Contribution Limits. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits.
- HSA Tax Advantages. https://www.hsacentral.net/consumers/tax-benefits-health-savings-account/#:~:text=HSA%20Tax%20Advantages,lowers%20your%20overall%20taxable%20income.
- HSA, HRA, healthcare FSA and dependent care eligibility list. https://www.hsabank.com/hsabank/learning-center/irs-qualified-medical-expenses.
- Publication 969 (2022), Health Savings Accounts and Other Tax-Favored Health Plans. https://www.irs.gov/pub/irs-pdf/p969.pdf.
- How to plan for rising health care costs. https://www.fidelity.com/viewpoints/personal-finance/plan-for-rising-health-care-costs.