Saving for Retirement: IRAs, 401(k)s, and More

As the number of defined-benefit pension plans steadily declines, the simpler days of expecting to reach retirement in good standing and start collecting a monthly pension check are gone for many people. Today, it's essential for workers to participate in and contribute to their own retirement plans. While Social Security is a valuable resource, most people will find it isn't enough to sustain their pre-retirement lifestyle after they stop working.

The saving and investing you do while you're employed will likely play a significant role in your financial life in retirement. So, it follows that the earlier you get started, the better. The key is to be realistic and build a plan you can follow.

Start by creating a disciplined, prudent savings plan that defines your retirement goals and includes a monthly savings amount. To help understand how much you might need to be putting away, you can use a retirement calculator or get more help by working with a financial planner.

The next step is to figure out where to put those savings.

Most people have two types of accounts available to them:

• Workplace retirement accounts, such as 401(k)s and 403(b)s¹
• Individual retirement accounts (IRA), including traditional and Roth IRAs

Whether you use one or multiple account types will depend on your work status, what type of plan your workplace offers, your income, and how much you're willing and able to save. So, which accounts, and what combinations, should you choose?

If you have access to a 401(k) or similar employer plan and your employer offers a matching contribution, the best place to start is depositing at least up to the amount matched. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping lower your current income tax bill. Your money—both contributions and potential earnings—grows tax-deferred until you withdraw it. At that time, withdrawals are taxed at your current tax rate. There may be state taxes as well. 

To understand why you'd want to start with your workplace plan, consider this example: Let's say you make $100,000 per year, and your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary (the average employer match is closer to 3%). In this case, at least the first $6,000 of savings you earmark for retirement should go into your 401(k). You don't want to give up the free money your employer is offering as a match.

After you fund your 401(k) enough to get the full company match, you can still set aside more money in a tax-advantaged way—including additional contributions into your 401(k) or contributions to a traditional or Roth IRA—up to annual limits (see table below). For most people, if you have a 401(k) through your employer, it's a good idea to continue to contribute as much as you can afford or what you calculate you need to reach your retirement savings goals, up to the annual limits.

One convenience of a 401(k) is that contributions are deducted automatically from each paycheck, making it easy to regularly contribute to your account. You're less likely to miss money that never shows up in your pocket or bank account in the first place—a behavior tested by time and science.

If you don't have access to an employer-sponsored plan like a 401(k) or if you're already contributing up to the annual limit, a traditional or Roth IRA can help increase your retirement savings.

One difference between the two IRAs is when and how your money is taxed:

• With a traditional IRA, contributions are made on a pre-tax basis, depending on your modified adjusted gross income (MAGI). Also, contributions are generally tax-deductible,² and you pay no taxes until you withdraw the money.³
• With a Roth IRA, contributions are made with after-tax dollars, meaning there's no potential tax deduction in the year of the contribution, but qualified withdrawals are tax-free in retirement as long as you've held the account for at least five years and you're older than age 59½. Be aware that to contribute to a Roth IRA, your income must be below certain limits.⁴ 

How should you decide between a traditional or Roth IRA? If you expect to be in a lower income tax bracket in retirement when you take withdrawals, a traditional IRA may be more beneficial. If you expect you to be in the same or higher tax bracket, a Roth IRA may make more sense—and it has other advantages over both a traditional IRA and 401(k), including no tax on your accumulated investment earnings.

Also, unlike 401(k) plans and traditional IRAs, Roth IRAs aren't subject to annual required minimum distributions (RMDs) starting at age 73. That's an advantage if you want your savings to have more opportunity to grow tax-free through the later years of your retirement. It could also benefit your heirs, who'd be able take money out income tax-free after you're gone. Note, though, that inherited Roth IRAs may be subject to RMDs for the beneficiary.

Finally, contributing to a Roth IRA is a way to add more flexibility to your tax situation in retirement—having accounts with pre-tax and post-tax funds gives you more options for income and tax planning.

More and more employers are making a Roth option available in their 401(k) plans. A Roth 401(k) account works much like a Roth IRA, but there is no income limit to prevent participation. For tax years 2023 and before, Roth 401(k)s are subject to RMDs. However, from 2024 onward, there will no longer be RMDs for Roth 401(k)s.

Assuming your employer offers the option, a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement or if you want flexibility and diversification in the way distributions will be taxed when you reach retirement, as described above. If you're in a lower bracket when you retire, then a traditional 401(k) may end up being the better choice, as you'd pay less tax on future withdrawals than you would pay making post-tax contributions to a Roth 401(k) today.

One way to hedge against uncertainty about future tax rates, your tax situation, or more flexibility to manage taxes in retirement may be to split your contributions between the traditional option and Roth option, assuming your employer makes both available.

Having multiple kinds of accounts would allow you to draw from across your taxable, tax-deferred, and tax-free accounts in a way that allows you to reduce your tax bill over time. So, instead of drawing from your tax-deferred accounts early in retirement and saving your tax-free accounts for later, you'd withdraw just enough from your taxable and tax-deferred accounts to "fill up" your tax bracket, and then tap tax-free sources for the remainder of your income needs each year.

If you've maxed out your 401(k) and IRA options, congratulations. You're making significant steps to save for retirement.

If you want to save even more, consider a:

Regular brokerage account

Traditional brokerage accounts don't offer the advantage of tax-free or tax-deferred investment earnings, but they can be relatively tax-efficient if managed smartly. Consider putting your least tax-efficient investments (actively managed mutual funds, REITs, and other securities where income is taxed when earned, for example) in your tax-advantaged retirement accounts and more tax-efficient investments (passively managed funds, exchanged-traded funds, municipal bonds, and stocks held for more than one year, for example) in taxable brokerage accounts.

Nondeductible contribution to a traditional IRA

Even if you're covered by an employer plan and you're above the income limit for a Roth IRA or a deductible contribution to a traditional IRA, you could make a nondeductible (after-tax) contribution to a traditional IRA—but whether you should is a tough call.

You won't receive an up-front deduction, and any earnings will be taxed as ordinary income when you withdraw them. Alternatively, you could make a contribution to a nondeductible IRA and then turn around and convert that to a Roth IRA. The rules for conversions can be complex, so be sure to speak with an appropriate tax or financial professional before doing a conversion.

The advantage of tax-deferral rests primarily on the potential for tax-deferred compounding. But there are also ways you can invest to delay or defer taxes in taxable brokerage accounts by not trading actively and investing tax-efficiently.

If you haven't started saving for retirement—or you're saving less than you should—get into the habit of "paying yourself first." That is, contribute as much as you can afford to your retirement accounts before spending the funds on nonessentials. Now that you know more about which retirement accounts may make the most sense, it's time to put your savings plan into action.