Since the 1980s, it's been the definitive American retirement plan, named after the corresponding section of the Internal Revenue Code: the 401(k). The setup is simple. With a 401(k), you contribute money from your paycheck every month. The money is automatically deducted from your check and invested in a particular fund. You get the proceeds when you retire. (For more on the 401(k), read The Basics of a 401(k) Retirement Plan and The 401(k) and Qualified Plans Tutorial.)
The upside – at least most people see it as one – is that a 401(k) can run on autopilot once you've got it established. You contribute a fixed amount monthly, your employer matches it, and as long as your salary never drops (and you keep your job), the theory goes that you'll wake up one day with a good chunk of money to help you through retirement. Even better is if your employer matches some percentage of your contributions.
The downsides are plenty. A major one is that you can't really set and forget a 401(k). If your salary doubles from x to 2x, and you're still contributing y every month, you're putting yourself at a disadvantage. But the fundamental shortcoming of the 401(k) is that the government's administrators forbid you from contributing more than $18,500 per year ($24,500 if you're at least 50.)
So, what else is out there for employees? Plenty. Explore these possibilities.
If your employer doesn't offer 401(k)s, you can join the self-employed and small business owners and invest in an individual retirement account (IRA). These accounts also offer retirement-oriented tax advantages, which differ depending on whether you choose a traditional or Roth IRA (see next section for differences). Even better, you can save in one in addition to a 401(k) – though, depending on your income and the type of account you choose, your contributions may not be tax deductible (click here for the details from the IRS). Even in that case, however, the money in your account will grow tax free until retirement.
Though both IRAs and 401(k)s offer tax benefits, but there are some key differences. With an IRA, the most you can contribute is $5,500 a year ($6,500 if you're at least 50). On the other hand, you can withdraw from an IRA without penalty if you get disabled or have to pay out-of-pocket medical expenses. (For more on IRAs, see 11 Things You May Not Know About Your IRA.)
With an IRA, the world is your investment oyster. You can invest in just about any security or financial instrument whose value can be measured precisely and daily. What it doesn't include are life insurance and collectibles. "Collectibles would be categorized as any work of art, metal, gem, alcoholic beverage, rug, antique or stamp," explains Rebecca Dawson, a financial advisor in Los Angeles, Calif. Your mint-condition Inverted Jenny 24¢ stamp might be worth $925,000, but that's only an estimate based on the price the most recent profligate rich person paid. It could take years to find a comparable rich person. One hundred shares of a stock, however, carry a value that you can calculate to the penny.
"The IRA is a great investment vehicle. However, more than 85% of investors aren’t aware of all the benefits that an IRA provides. It allows you to invest in stocks, bonds, and mutual funds, but it also allows you to invest in real estate, horses, private company stock, tax liens, farmland, cryptocurrency, franchises, physical gold and more," says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass.
Like 401(k)s, IRAs come in both traditional and Roth versions. Do you want to pay taxes now, or later?
With a traditional IRA, you deduct the contributions from your taxes today, and pay income taxes when you start withdrawing decades down the road. (To learn more, read IRA Contributions: Deductions and Tax Credits.)
With a Roth IRA, you don't get to deduct the contributions from your annual tax bill, but once you start withdrawing, it's all tax free. Any growth is tax free too, so if you're under 50 it's almost always going to be a better deal to go with a Roth IRA over a traditional one. You do have to ask yourself if you're going to be in a higher tax bracket once you retire, and if the tax brackets in the future will bear any resemblance to today's. Twenty-three years ago, the highest marginal tax rate in the United States was 28%. Twenty-four years before that, it was 91%. If you can accurately predict where Congress and the president will set the limits 24 years from now, maybe your clairvoyance extends to picking stocks, too.
Finally, there are regular old investment accounts. You go to a broker with a cashier's check in hand, open an account and "contribute" as much as you want, or can. Any profit, whether from appreciation or dividends, will likely be taxed as long-term capital gains, which likely means you'll pay a lower rate than you'd pay on ordinary income. On the other hand, this is your investment and nobody else's. Its care and feeding are your responsibility.
"While contributing to a 401(k) or traditional or Roth IRA has great benefits, like deferred taxes or tax-free growth, annual limits may prevent you from investing enough capital to enjoy a sufficient retirement income later. Supplementing a retirement account with a taxable account invested in an appropriate stock fund and bond fund allocation can supercharge your financial plan and support a desired outcome," says Daniel Schutte, MBA, Credo Wealth Management, Denver, Colo.
"Many self-employed people find themselves later in life with a high income and very little to show for it in the way of retirement savings. My favorite solution for such a person is a cash-balance defined-benefit plan, where the annual contribution in 2017 could potentially be as high as $209,203," says Robert R. Schulz, CFP®, president of Schulz Wealth, Mansfield, Texas.
If you're disciplined enough to ride out the inevitable lows, breathe deeply during the highs, and treat irrationality and panic like the leeches they are, a standard investment account might be the way to go. But they take a lot of effort to maintain and you may owe capital gains on income growth. Which isn't to say that you should check your portfolio value every day, but rather that you should constantly be on the lookout for undervalued investments and, of course, determine if you're inadvertently carrying any overvalued ones. Most people find it far easier to let someone else do the work. (For more options, see Which Retirement Plan Is Best?)