The Best Retirement Plans to Build Your Nest Egg

A pension and Social Security benefits were once enough to cover expenses during retirement. Today, most people fund their own post-work years with various retirement plans offering tax breaks and other benefits.

Here's a look at the scenarios and factors to consider when you choose a retirement savings plan.

Roth IRA vs. Traditional IRA

Individual retirement accounts, or IRAs, are tax-advantaged accounts with two main types, traditional and Roth. You must have earned income in wages or salaries to contribute to either. If you are eligible for both types of IRA, your choice depends on when you want to pay taxes, now with a Roth IRA or in retirement with a traditional IRA.

The limits and the tax benefits for IRAs are set by the Internal Revenue Service (IRS). The contribution limits for traditional IRAs and Roth IRAs are the same. For 2023, you can contribute up to $6,500, plus an additional $1,000 for those 50 or older. The SECURE 2.0 Act of 2022 added an IRS cost-of-living-adjustment (COLA) effective for taxable years beginning after Dec. 31, 2023, for catch-up contributions.

You must take the required minimum distributions (RMDs) from a traditional IRA at age 73 in 2023. The age will increase to 75 in 2033.Roth IRAs do not require RMDs during the owner's lifetime, making a Roth IRA a wealth-transfer vehicle because you can pass the entire account and its tax benefits onto your heirs.

For some beneficiaries, the required minimum distribution rules state that all funds must be distributed by the end of the 10th year after the original account owner's death. There are exceptions for eligible designated beneficiaries, such as a spouse.

IRA Income Limits and Contributions

Traditional IRA

With a traditional IRA, you can deduct your contributions but you pay taxes on withdrawals in retirement. You can always deduct your contributions in full only if you and your spouse don't have a 401(k) or another retirement plan from your employer, as your deduction could be reduced or eliminated, depending on your income.

Here are the 2022 and 2023 contribution limits per the IRS.

Roth IRA

With a Roth IRA, your contribution isn't tax deductible, but qualified distributions are free of taxes and penalties.It must be at least five years since you first contributed to a Roth, and one of the following must also hold:

• You have reached the age of 59½.
• You have a disability.
• You are using the distribution to buy a first home.
• You have died, and your beneficiary receives the distributions.

Roth IRAs have income limits for contributions based on your modified adjusted gross income (MAGI) and filing status.

There is, however, a backdoor way to contribute to a Roth IRA if you are above that income limit. To help you decide which IRA to invest in, look at your current tax bracket compared to your projected tax bracket during retirement. Try to choose which plan results in lower taxes and more income (granted, determining this may not be easy).

In general, a Roth is the better choice if you expect to be in a higher tax bracket in retirement, or if you expect to have significant earnings in the account. As long as you take qualified distributions, you won't ever pay taxes on earnings.

401(k) Plans

401(k) plans are tax-advantaged accounts to save for retirement and are offered by employers. 401(k)s are defined contribution plans where employees contribute through automatic payroll withholding and the employer can add money through an employer match. Your employer might contribute up to 5% of your salary as long as you put in at least that amount yourself.

401(k) Contributions

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. After Dec. 31, 2024, the catch-up 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.

You may be eligible to make traditional IRA or Roth IRA contributions as well as salary deferral contributions to a 401(k) plan but not be able to afford to do both. Some of the following concepts can apply if you have the option of contributing to both a traditional 401(k) and a Roth 401(k).

Let’s look at River, who works for Company A and is eligible to make a salary deferral to Company A’s 401(k) plan. River’s annual compensation is $50,000, and they can afford to contribute $2,000 each year, which they have decided to put into one account to avoid excessive fees. Therefore, River must decide whether it makes better financial sense to contribute to the 401(k) or to an IRA.

401 (k) With Company Match

River works for Company A and is eligible to make a salary deferral to Company A’s 401(k) plan. With an annual compensation of $50,000, River can afford to contribute $2,000 annually but must decide whether it makes better financial sense to contribute to the 401(k) or an IRA.

If Company A provides a matching contribution on salary deferral contributions, 401(k) will be the better choice. Below is a look at the growth of the accounts over ten years, assuming an employer match of $1 for each $1 River contributes, up to 3% of their salary.

River will receive a matching contribution of $1,500 ($50,000 x 3%). In 10 years, their 401(k) would grow significantly faster than an IRA.

401 (k) Without Company Match

If Company A isn't making matching contributions to the 401(k) plan it offers, River should consider the following questions before deciding whether to invest in the 401(k):

Which investment choices are available? 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 are typically more likely to allow self-direction of investments.

What are the 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.

Are the 401(k) funds accessible? Though retirement savings are intended to accumulate until retirement, situations sometimes arise that leave a participant no choice but to make withdrawals or take out a loan from their retirement accounts. Assets in a 401(k) plan cannot be withdrawn unless the participant experiences a triggering event. However, if Company A's plan has a loan feature, River could take a loan from their 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.

What's the cost of professional management? River may need the services of a professional investment advisor to make sure asset allocations are consistent with retirement goals and objectives. If River's employer provides those services as part of its employee benefits package, River 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.

What about 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, like River, are subject to income limits on how much of the contribution is deductible. Contributions to a Roth IRA are not tax deductible at all.

Contributing to Both 401(k) and IRA

TJ can afford to fund a 401(k), a traditional IRA, and a Roth IRA with $7,000 annually and should consider the following:

Getting the Maximum Match

If a matching contribution is made to the 401(k) plan, consider the maximum amount they need to contribute to receive the maximum available matching contribution. If TJ's salary is $80,000 per year, and the match is $1 for $1 for up to 3% of compensation, they will need to contribute at least $2,400 to their 401(k) plan to receive the maximum available matching contribution of $2,400.

Choosing Between IRAs

If TJ puts $2,400 into their 401(k), they'll have $4,600 left for their IRA contribution. TJ will have to do the math to find out how much of their traditional IRA contributions would be tax deductible and factor that into their decision to choose a Roth IRA, a traditional IRA, or a combination of the two and their total contribution to both IRAs cannot exceed the limit for that tax year.

Which to Fund First

It is usually best to contribute to the retirement accounts early in the year, or monthly to accumulate earnings as soon as possible. Some companies contribute the amount in one lump sum at the end of their tax-filing deadline, while others contribute amounts throughout the year.

Setting Up a Backdoor Roth IRA

High-income earners can’t contribute directly to a Roth IRA but can indirectly contribute to a backdoor Roth IRA. A traditional IRA doesn’t limit or prevent individuals with higher incomes from contributing.

Step 1: 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.

Step 2. 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.

Step 3. 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.

Time Horizon and Beneficiaries

Your time horizon and age are factors when determining proper asset allocation. If you are at least age 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 to avoid RMDs that will lower the balance in your accounts. Roth IRAs and Roth 401(k)s allow you to pay taxes when you make the initial contributions. For Roth IRAs, the RMD rules do not apply to the IRA owner, which allows for a larger balance to be left to beneficiaries.

The Bottom Line

For those eligible to fund multiple retirement accounts and have the money, the choice is not an issue. For those who don't have money to contribute to multiple plans, picking the best options can be challenging. Whether you prefer to take the tax breaks on the back end with Roth IRAs or on the front end with traditional IRAs can be a determining factor. The purpose of the account as retirement income or estate planning should be considered. A competent retirement planning advisor can help individuals make practical choices.