401k, IRA, Roth IRA. Sounds Greek, but we can keep track of three right? Oh, but there’s also the Roth 401k. And 401a, 403b and 457s. If you’ve heard some of these plans mentioned, you might be scratching your head. In its infinite wisdom, our government has created all these plans for different kinds of situations.
The biggest difference between all these plans is who they are available to. Each plan also allows different contribution amounts per year. The IRS updates the limits every year on their website.
What’s Offered To Who?
Fortunately or unfortunately, you won’t have to spend too much time thinking about all these account types, since most are likely not available to you. Anyone can contribute to a traditional IRA. Roth IRAs are available to anyone making less than these income limits. A 401k is available to private sector employees, but only if your employer chooses to offer it. The 401a is a less common private sector plan, also available through your employer and non voluntary if offered. 403(b)s and 457s are available to different kinds of public sector and non-profit employers. Other than 457, all the plans come in both traditional and Roth varieties. In addition to these retirement account types, any employer can offer their own pension plan, which is treated as regular income in retirement.
So What Should I Choose?
Your options are likely limited to whatever retirement your employer offers and IRAs. Many employers offer a matching contribution with their plan. Their match is usually capped at a certain percentage of your pay. At the very least, contribute enough to get the full match. Not doing so is saying no to free money.
If your biggest priority is convenience and you don’t anticipate switching jobs often, your employers plan is likely your best option. Your employer does all the leg work of setting up the plan and contributions are automatic by nature. Other than opting in to the plan, all you need to do is select investments. Even though the plan likely has a default selection, you should explore the options. Look for funds with low expense ratios and no or low fees.
If you anticipate many job changes, it will probably be easier to primarily use IRAs. Of course, still max out the employer match. When you leave a job, you’ll be able to transfer your employer’s retirement plan into an IRA. I doubt you’ll want to think about setting up an IRA during a job change. One note- it is easier to transfer from a traditional 401k to a traditional IRA, or from a Roth 401k to a Roth IRA than from a traditional to a Roth or vice-versa.
IRAs also offer more flexibility than employer sponsored plans. Employer sponsored plans offer a limited number of mutual funds that they have selected. IRAs are brokerage accounts, giving you access to the entire investment world and allowing you to buy and sell investments as you wish. This isn’t necessarily a good thing, but it can be. You should approach your retirement plan with a “buy and hold” mentality. You want to pick one or a few good investment funds (not individual stocks) and stick with them. You only want to mess with your allocations to adjust your risk level as you approach retirement. If having the stock market at your fingertips turns you into a day trader, you may be better off with your employer’s plan.
If, however, your employer’s plan only offers actively managed, expensive mutual funds, you’re better off investing in low cost index funds through an IRA. Actively managed funds don’t boast any better record than index funds, but still come with much higher fees.
If your finances are in great shape and you’ve budgeted a good chunk for retirement, you might find yourself bumping up against the contribution limits for one or more account types available to you. In this case, you’ll have to spread your contributions across multiple plans. Pat yourself on the back, because this is a good problem to have.
Roth vs traditional
When you’ve picked your employer’s plan or an IRA, or both, you still have to decide whether to pick the Roth or traditional option. The difference is when you get taxed. In a traditional plan your contributions are tax exempt, lowering your current tax bill. When you retire, you will have to pay taxes on all your withdrawals. With a Roth, you invest after tax money, but all your retirement withdrawals will be tax free. Deciding between the two largely comes down to what tax bracket you are currently in, and what tax bracket you’ll be in when you retire. If you are currently in a low tax bracket, and your retirement looks strong, you are probably best off with a Roth account.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.