How to choose the right tax-advantaged retirement account for you.
You can use a number of strategies to help you save for retirement, including tax-advantaged retirement accounts like traditional or Roth 401(k)s and IRAs, or other investment accounts. The best retirement plan to build your nest egg will depend on your financial situation, your goals for retirement, and other factors.
Let’s look in more detail at the various ways to save for retirement, how each savings plan works, and about their disadvantages and advantages.
KEY TAKEAWAYS
- Tax-advantaged savings accounts like traditional or Roth IRA and 401(k)s are among the best retirement plans to build your nest egg.
- Roth and traditional retirement accounts have different tax advantages.
- Traditional 401(k)s and IRAs allow for pre-tax contributions, reducing your annual income tax for that year.
- Contributions to Roth 401(k)s and IRAs are made with after-tax funds, but you can withdraw them in retirement tax-free.
- The best retirement account to build your nest egg will depend on your specific situation and financial goals.
401(k)s vs. IRAs
The main difference between 401(k)s and IRAs is that 401(k) plans are offered through an employer and they have larger contribution limits. An employer offering a 401(k) plan may also offer matching contributions up to a certain amount.
IRAs, on the other hand, are held by an individual and typically offer more investment choices, but the contribution limit is lower. They may also include income limits.
Among 401(k)s and IRAs, you can choose between traditional or Roth accounts. The main difference between them is their tax advantages. With a traditional tax-advantaged retirement account, your contributions are made with after-tax dollars, so your tax bill for that year is lower. Then, you pay taxes on withdrawals during retirement.
With Roth accounts, tax advantages come in your retirement years. You can make tax-free withdrawals from a Roth account during retirement, and that includes any gains your investments have made. Roth IRAs have income limits.
Let’s look in more detail at the limits and tax advantages of different retirement plans to build a nest egg, so you can determine which may be right for you.
401(k)s
401(k) plans are tax-advantaged accounts to save for retirement and are defined contribution plans offered by employers. Employees contribute through automatic payroll withholding and the employer can add money to provide matching contributions. For example, your employer might contribute up to 5% of your salary if you put in that amount.
Note: Contributions to a traditional 401(k) are made with pre-tax income, effectively lowering your tax bill for the year. But you will pay income taxes when you make withdrawals in retirement. Depending on your financial situation, you may be in a lower income tax bracket when you retire.
A Roth 401(k) is similar to a traditional 401(k) in that it is provided by an employer. However, contributions to a Roth account are made with after-tax funds. You get your tax advantage in your retirement years when you can withdraw the funds, including any gains on investments, tax-free.3
You must start taking distributions from your 401(k) when you turn 73 unless you are still working. You can delay taking the minimum required distributions until the year you retire.
401(k) Contribution Limits
For 2023, you can contribute up to $22,500 to your 401(k), or $30,000 if you’re age 50 or older with a $7,500 catch-up contribution. For 2024, the contribution increases to $23,000 but the catch-up contribution stays at $7,500. After Dec. 31, 2024, the catch-up contribution limits for 401(k) plan participants aged 60 to 63 increase to the greater of $10,000 or 150% of the standard catch-up amount for that year.
Employers can contribute up to $66,000 in 2023, or $73,500 if the employee is age 50 or older. For 2024, that increases to $69,000 or $76,500, respectively.
Note: The IRS adjusts contribution limits for tax-advantaged retirement accounts annually for inflation.
IRAs
Individual retirement accounts, or IRAs, are held by you, not your employer. But you must have earned income in wages or salaries to contribute.
With traditional IRAs, you can deduct your contributions from your taxable income, however, you will have to pay taxes on withdrawals when you reach your retirement years. You must take the required minimum distributions (RMDs) from a traditional IRA starting at age 73 in 2023. The age will increase to 75 in 2033.
With Roth IRAs, contributions are made with after-tax dollars, so your tax benefit is not immediate. However, you can make withdrawals tax-free in your retirement years, or after age 59½. Roth IRAs do not require RMDs during the owner’s lifetime.
However, you must meet certain criteria before you can make tax-free withdrawals from a Roth IRA. You must have held the account for at least five years, and you must meet one of the following criteria:
- You have reached the age of 59½.
- You have a disability.
- You are using the distribution to buy a first home.
IRA Contribution and Deduction Limits
For 2023, you can contribute up to $6,500, plus an additional $1,000 for those 50 or older. For 2024, the figure increases to $7,000 while the catch-up contribution stays at $1,000. Unlike with 401(k)s, your income will play a role in how much you can contribute to a Roth IRA and the amount of deduction you can take for a traditional IRA.
Important: Beginning in 2024, the SECURE 2.0 Act of 2022 allows you to access up to $1,000 annually from retirement savings for emergency expenses. It permits survivors of domestic abuse to withdraw the lesser of $10,000 or 50% of their retirement account and lets victims of a qualified federally declared natural disaster withdraw up to $22,000 from their retirement account without penalty.
Other Retirement Accounts
Other tax-advantaged retirement accounts can apply to different situations such as SIMPLE 401 (k) plans, 403(b) plans, SIMPLE IRA plans, and SEP plans. Once you have maxed out contributions to a tax-advantaged account, you may want to turn to a traditional investing account to help your nest egg grow.
By investing in assets like stocks and bonds, you have the potential to earn significantly more profits than you would if you simply held cash. However, you should plan to pay taxes on gains earned on your investments. You may also incur trading fees that can affect your profits.
Consider consulting with a professional advisor who can help you choose investments that match your financial goals and risk tolerance level.
Tip: Order your copy of the print edition of Investopedia’s Retirement Guide for more assistance in building the best plan for your retirement.
How a 401(k) With Company Match Works
To illustrate how a 401(k) with company match works, consider an example where you work for Company A, which offers a 401(k) plan. You plan to contribute $2,000 each year toward your retirement and you are deciding whether it makes better financial sense to contribute to the 401(k) or to an IRA.
If Company A provides a matching contribution, a 401(k) will be the better choice. Below is a look at the growth of the accounts over 10 years, assuming an employer match of $1 for each $1 you contribute, up to $1,500. In 10 years, your 401(k) would grow significantly faster than an IRA.
What to Consider When Choosing a Retirement Plan
Matching contribution plans are typically the best retirement plans to build your nest egg. But if your employer isn’t making matching contributions to the 401(k) plan it offers, consider several factors before deciding which retirement account to use:
Investment choices: Large corporations typically limit investment choices to mutual funds, bonds, and money market instruments, similar to the investment options available in a self-directed IRA. Smaller companies may do the same, but they are typically more likely to allow self-direction of investments.
Fees: Fees that are charged to 401(k) accounts are not as visible as the fees that are charged to an IRA, leading many participants to believe that 401(k) fees are minimal to nonexistent.
Accessibility: Assets in a 401(k) plan cannot be withdrawn unless the participant experiences a triggering event. However, if a company’s plan has a loan feature, you may be able to take a loan from your account and repay it. IRA assets can technically be withdrawn at any time. However, if you’re under the age of 59½, your distribution will be considered taxable income, and it may be subject to a 10% penalty.
Management costs: You may need the services of a professional investment advisor to make sure asset allocations align with your retirement goals and objectives. If your employer provides those services as part of its employee benefits package, you won’t incur an additional cost, however, this perk may not be available for an IRA unless an employer extends such services to assets outside of its employer-sponsored plan.
Tax deductions: Contributions to a 401(k) reduce taxable income as do contributions to a traditional IRA. Those employed by a company with a retirement plan are subject to income limits on how much of the contribution is deductible. Contributions to a Roth IRA are not tax deductible.
Important: Beginning in 2025, the SECURE 2.0 Act of 2022 requires employers to automatically enroll eligible employees in new 401(k) plans with a participation amount of at least 3% but no more than 10%. The contribution escalates at the rate of 1% per year up to a minimum of 10% and a maximum of 15%.
Contributing to Both a 401(k) and an IRA
You can contribute to both a 401(k) and an IRA. For example, you could contribute up to the maximum employer matching amount for a 401(k) and then contribute to an IRA.
You could also contribute to both a Roth IRA and a traditional IRA, but your total contributions to the two accounts combined cannot exceed the IRS maximum amount.
Setting Up a Backdoor Roth IRA
High-income earners can’t contribute directly to a Roth IRA, but they can indirectly contribute to a backdoor Roth IRA. A traditional IRA doesn’t limit or prevent individuals with higher incomes from contributing. Here’s how to set up a backdoor Roth IRA:
- Contribute to a traditional IRA: There are no income limits for making this contribution and it may already be after-tax money if your income exceeds the limits.
- Immediately convert your traditional IRA to a Roth IRA: Ideally, do this before your traditional IRA contribution has generated any earnings that will have to be taxed when you do your conversion.
- Follow the tax rules: If you took a deduction on your pre-tax contributions from your traditional IRA, you owe taxes when you convert them to a Roth IRA, which is funded with after-tax income.
If you cannot deduct your traditional IRA contribution in step 1, you won’t owe further taxes except on any earnings if your conversion happened after your contribution generated income. If you have other money in traditional IRAs, there is a pro-rata rule for taxes on a Roth IRA conversion.
If your employer permits traditional 401(k)s to be rolled over to either your company’s Roth 401(k) plan or to an outside IRA, you may be in a position to move a considerable amount of money into a Roth account where it can grow tax-free and provide tax-free distributions at retirement. This strategy requires sophisticated advice about what you might owe in taxes when you convert.
Time Horizon and Beneficiaries
Your time horizon and age are factors when determining proper asset allocation. If you are at least 50, participating in a plan that includes a catch-up contribution feature can be an attractive choice, especially if you are behind in accumulating a retirement nest egg.
Though retirement accounts are usually intended to finance your retirement years, some people plan to leave these accounts to their beneficiaries. You will need to evaluate your tax-free or taxable assets and whether you want to avoid RMDs that will lower the balance in your accounts. For Roth IRAs, the RMD rules do not apply to the IRA owner, which allows for a larger balance to be left to beneficiaries.
How Inflation Can Impact Your Nest Egg
As you develop your retirement plan to build your nest egg, keep in mind the impact of inflation, or the increase in the cost of goods and services. Inflation can erode the value of your nest egg, but there are ways to prepare for it. For example, you can take inflation into account as you plan a budget and establish your income goals for retirement.
Important: Treasury Inflation-Protected Securities (TIPS), high-yield bonds, and shorter-duration bonds are among the types of assets that can be resistant to inflation. Consult with a professional financial advisor to find the right asset allocation for your personal situation and goals.
You can also ensure your portfolio is well diversified. If the growth of your investments does not match the rate of inflation, you will essentially lose money. So, if your portfolio grows by an average of 4% per year, but inflation averages 5% per year, the value of your investments would actually decline in terms of how it can support you in retirement.
The federal government uses inflation as a benchmark when deciding whether to raise Social Security benefits or whether to increase contribution limits to tax-advantaged retirement plans.
What Are the Best Options for Retirement Planning?
Individual retirement plans include traditional IRAs, Roth IRAs, and spousal IRAs. Anyone who earns income can open these on their own. The best employer-sponsored retirement plans include 401(k)s, 403(b)s, and 457(b)s.
How Much Can I Contribute to My 401(k)?
The annual contribution limit to a 401(k) for 2023 is $22,500 in 2023. If you are 50 and over, you can contribute an additional $7,500. The contribution limits increased for 2024 to $23,000 with the same catch-up contribution.
What Is a Good Amount of Money for Retirement?
The appropriate amount of money considered “good” for retirement is based on your current lifestyle, desired lifestyle in retirement, obligations, and health. Some financial advisors recommend that your annual retirement income equal 80% of your last job’s annual income.
The Bottom Line
The best retirement plan to build your nest egg will depend on a number of factors, but generally plans that offer an employer match will provide the most growth. After you’ve contributed up to an employer match, choosing the best options for your retirement funds can be challenging. Weigh the factors like fees and taxation and consider consulting a professional retirement planning advisor for more guidance on your specific financial situation.
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