The Best Alternatives to a 401(k)

Top 401(k) Alternatives

The 401(k) plan, since its inception in 1978, has been become the most popular employer-sponsored retirement plan in the U.S. But not all workers have access to one, leaving them to seek alternatives to save for retirement.

So what else is out there? There are several options. But first, let's take a look at how a 401(k) works.

Key Takeaways

  • Not all workers have access to a 401(k), a popular employer-sponsored retirement plan.
  • Some alternatives for retirement savers include IRAs and qualified investment accounts.
  • IRAs, like 401(k)s, offer tax advantages for retirement savers.
  • If you qualify for the Roth option, consider your current and future tax situation to decide between a traditional IRA and a Roth.

Understanding 401(k) plans

With a 401(k), you contribute pretax money from your paycheck every month. Contributions are tax-deductible from your annual income. The money is automatically deducted from your paycheck and invested in the investments you choose from the plan's options.

Even better is if your employer matches some percentage of your contributions, which many do. You get the proceeds of the investments when you retire.

There are annual contribution limits to 401(k)s established by the Internal Revenue Service (IRS). In 2021, the 401(k) contribution limit is $19,500 per year, and in 2022, the limit is $20,500. For those aged 50 and older, an additional catch-up contribution is allowed of $6,500 per year in 2021 and 2022.

While a 401(k) can run on autopilot once you've got it established, this isn't typically a good idea. If, for example, your salary doubles and you're still contributing the same amount every month, you're putting yourself at a disadvantage by not increasing contributions. However, some employers allow a percentage of income to be withdrawn from an employee's income each pay period, which can help to increase savings if your salary increases.

For those looking for alternatives to a 401(k), consider exploring the possibilities below.

Traditional and Roth IRAs

If your employer doesn't offer a 401(k)—or you are self-employed or a small business owner—you can open 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.

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. Even in that case, however, the money in your account will grow tax-free until retirement.

Although IRAs and 401(k)s offer tax benefits, there are some key differences. With an IRA, the most you can contribute in both 2021 and 2022 is $6,000 a year ($7,000 if you're at least 50).

In general, 401(k)s and IRAs have an early withdrawal penalty if you take distributions before age 59½, but there are exceptions to this rule.

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, California.

"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, Massachusetts.

Traditional vs. Roth IRAs

Like 401(k)s, IRAs come in both traditional and Roth versions. The choice between the two IRA accounts typically depends on whether you want to pay taxes now or later.

With a traditional IRA, you deduct the contributions from your taxes today, and you only pay income taxes when you start withdrawing—decades down the road.

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 earnings or investment growth is tax-free, too. You are also spared the required minimum distributions when you hit age 72, which are mandated for traditional IRAs and 401(k)s.

When deciding between a traditional or Roth IRA, 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 your bracket today.

SEP IRAs

If you are self-employed or a small business owner, you may also have the option to open a simplified employee pension (SEP-IRA) if you qualify. SEP-IRAs operate much like traditional IRAs in terms of tax advantages and investment options. They have the additional benefit of higher contribution limits.

Contributions cannot exceed 25% of compensation for the year or $58,000 (for 2021) and $61,000 (for 2022), whichever is less.

Cash-Balance Defined-Benefit Plan

If you're self-employed and successful but were too busy—or too low on cash—to do much about building up a retirement plan earlier in your life, there's still time to do something to secure your future. A cash-balance defined-benefit plan will let you play instant retirement catch-up.

Robert R. Schulz, CFP®, president of Schulz Wealth in Mansfield, Texas, explains it this way:

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 2021 could potentially be as high as $230,000.

Please note that the above quotation was written before the IRS made changes. The annual benefit under a defined benefit plan was increased for 2022 to $245,000 by the IRS.

The Investment Account

Finally, there are regular old investment accounts. You can open an account at your preferred financial institution and "contribute" as much as you want or can. Any profit, whether from appreciation or dividends, will be taxed as long-term capital gains as long as the investments are held for more than one year. This likely means you'll pay a lower rate than you'd pay on ordinary income.

Daniel Schutte, of Schutte Financial in Denver, Colorado, explains this situation as follows:

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.

If you're disciplined enough to ride out the inevitable lows and breathe deeply during the highs, 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.

Article Sources
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  1. U.S. Bureau of Labor Statistics. "Defined Contribution Retirement Plans: Who Has Them and What Do They Cost?" Page 8. Accessed Jan. 16, 2022.

  2. Internal Revenue Service. "401(k) Plan Overview." Accessed Jan. 16, 2022.

  3. Internal Revenue Service. "IRS Announces 401(k) Limit Increases to $20,500." Accessed Jan. 16, 2022.

  4. Internal Revenue Service. "Traditional and Roth IRAs." Accessed Jan. 16, 2022.

  5. Internal Revenue Service. "Retirement Topics - Exceptions to Tax on Early Distributions." Accessed Jan. 16, 2022.

  6. Internal Revenue Service. "IRA FAQs." Accessed Jan. 16, 2022.

  7. Internal Revenue Service. "Retirement Topics — Required Minimum Distributions (RMDs)." Accessed Jan. 16, 2022.

  8. Internal Revenue Service. "Simplified Employee Pension Plan (SEP)." Accessed Jan. 16, 2022.

  9. Internal Revenue Service. "SEP Contribution Limits (Including Grandfathered SARSEPs)." Accessed Jan. 16, 2022.

  10. Internal Revenue Service. “2022 Limitations Adjusted as Provided in Section 415(d),” Page 1. Accessed Jan. 16, 2022.

  11. Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Jan. 16, 2022.

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