Few resources can help get you as financially prepared for retirement as retirement accounts. Saving money for retirement while simultaneously getting tax breaks is a 2-for-1 benefit that can work wonders for retirees.
A handful of retirement accounts are available, with the most popular being a 401(k) because it’s offered through employers. Many people think about maxing out their 401(k), and while that’s a commendable goal, there may also be a better route for retirement savings.
Image source: Getty Images.
Get your employer match, then focus on an IRA
An employer match is when your company matches up to a certain percentage or amount of your 401(k) contributions. The least amount you should contribute to a 401(k) is the most your employer will match. Contributing anything less is leaving free money on the table.
Once you’re contributing the most your employer will match, I recommend switching your focus to maxing out an IRA over maxing out your 401(k). Once you’ve maxed out an IRA, you should refocus on maxing out your 401(k).
The maximum amount you can contribute to an IRA (traditional and Roth combined) in 2024 is $7,000. If you’re 50 or older, you can add an extra $1,000 catch-up contribution, bringing it to $8,000. The most you can contribute to a 401(k) in 2024 is $22,500 ($30,000 if you’re 50 or older), so the IRA limit is much lower and more manageable to max out.
Of course, if you’re financially able to do both, go for it. However, that’s not an option for most people.
The two main types of IRAs to consider
The two main types of IRAs are traditional and Roth, each with unique benefits.
A traditional IRA is closer to a 401(k) because each allows you to deduct your contributions from your taxable income for the year. In the case of a traditional IRA, whether your contributions are deductible depends on your filing status, income, and if you’re covered by a work-sponsored retirement plan.
In a Roth IRA, your tax break comes in retirement. You contribute after-tax money and then take tax-free withdrawals in retirement if you’re 59 1/2 years old and made your first contribution at least five years prior.
Having several investment options is beneficial
I recommend prioritizing an IRA over maxing out your 401(k) because of the benefits IRAs offer that 401(k)s don’t.
To begin, you have lots of investment options with an IRA. In a 401(k), you’re forced to choose from the provided options. IRAs allow you to invest in virtually any stock or exchange-traded fund (ETF) you could in your regular brokerage account.
The freedom to tailor your investments however you see fit is important in investing, especially retirement investing. Everyone has different risk tolerances, financial and retirement goals, and time horizons. What works for one person may be counterproductive for someone else.
For example, in your 30s, it’s generally easier to take more risks for the chance at higher gains than when you’re within a decade of retirement and need to focus more on preserving what you’ve made to that point.
Withdrawal flexibility can help with major life events
IRAs also have more flexible early withdrawal rules. Generally, when you withdraw early from a retirement account, you’ll face a 10% penalty and owe taxes on the withdrawn amount. However, IRAs have more exceptions to this rule that can benefit you for various life events.
First-time homebuyers can withdraw up to $10,000 to put toward their purchase; you can cover qualified education expenses like tuition, books, and other student fees; you can cover your healthcare premiums while you’re unemployed; and a few other exceptions that don’t apply to a 401(k).
Choosing between a traditional and Roth IRA
Choosing between a traditional and Roth IRA generally comes down to your current tax rate versus your projected tax rate in retirement and when you want to pay taxes.
A traditional IRA may be a good option for people in their peak earning years who anticipate being in a lower tax bracket in retirement, because you can take the tax break now while your bracket is higher. Conversely, a Roth IRA could benefit someone who anticipates being in a higher bracket in retirement because you can pay taxes now at a lower rate.
Regardless of your choice, it’s important to consider it a collaboration with a 401(k). IRAs and 401(k)s have pros and cons and are best used to tackle retirement savings as a team. The more resources you use the better, because you maximize the pros of each while minimizing the cons.