Unfortunately, not everyone is lucky enough to have an employer-sponsored retirement plan like a 401(k), and even fewer people have 401(k) matching. An employer-sponsored plan is great because it allows you to save for retirement without having to think about it too much. For the rest of us, saving for retirement requires a more active approach. Below I lay out the general options available. For those who are self-employed, keep in mind that there are additional retirement plan options that I do not cover here.
Individual Retirement Accounts (IRAs)
IRAs are tax-advantaged accounts that allow individuals to either defer taxes now or avoid taxes in the future. In the meantime, your money can grow tax-free. In 2020 and 2021, total contributions are limited to $6,000 per year (or $7,000 if you are 50 or older). If your earned income is less than the limit, then you are only allowed to contribute up to 100% of your earned income. You can also use your spouse’s income to reach this limit if filing a joint return. Contributions must be made by the federal income tax filing deadline of the next year. This means that you have until May 17th of this year to make your 2020 contribution.
The main types of IRAs are Roth IRAs and traditional IRAs. Both can be opened at most brokerage services. I describe the differences between these accounts below.
A Roth IRA, established by the Taxpayer Relief Act of 1997 and named after its primary legislative sponsor, is a great way to save for retirement if you are currently in a lower tax bracket than you think you will be in when you are retired. This account requires you to contribute after-tax money, which means that you don’t get the immediate tax benefits of the traditional IRA, but it has a number of advantages.
The biggest advantage is that, since you already paid taxes on your contributions, you will not need to pay any taxes on your withdrawals, assuming you follow the withdrawal rules. This means that your money can grow tax-free, and you will not have to pay any taxes on your profits. You can also withdraw your contributions at any time without penalty. Earnings can only be withdrawn tax- and penalty-free after age 59.5, assuming the account is at least 5 years old. Otherwise, your distributions will be subject to income tax and a 10% penalty. There is an exception for first-time homebuyers, who can withdraw up to $10,000 in earnings tax- and penalty-free to buy, build, or rebuild a home. You can also withdraw earnings penalty-free to pay for qualified higher education expenses, but you will have to pay income taxes. You can read more about Roth IRA withdrawals here.
Roth IRAs are meant for individuals with lower incomes, so there is an income cap for making contributions. For 2020, the cap for contributing the full amount is a modified AGI of $124,000 for a single filer and $196,000 for a married couple filing jointly. The amounts you can contribute is phased out up to an income of $139,000 and $206,000, respectively. For more information, see the IRS guidelines. If your income is over the threshold, you may still be able to use a backdoor Roth IRA strategy.
Traditional IRAs were established earlier than Roth IRAs, coming into being due to the Employee Retirement Income Security Act of 1974. These are also known as tax-deferred accounts because you may be able to deduct your contributions from your federal income tax (see deduction limits here) and your money can grow tax-free in the account. However, your withdrawals are subject to ordinary income tax. Like Roth IRAs, you also pay a 10% penalty for withdrawals before 59.5, except in certain circumstances.
One significant difference from Roth IRAs, aside from the taxable nature of withdrawals, is that you must take required minimum distributions (RMDs) from your traditional IRAs once you reach age 72. These distributions are quite large (25.6% of your account balance at age 72) but decrease in size as you age. You can see the RMDs you will have to take here (keep in mind the age requirement was raised from 70.5 to 72 with the passing of the SECURE Act in 2019). If you do not withdraw your full RMD, you will have to pay a penalty of 50% of the amount you did not withdraw.
Generally, traditional IRAs are preferable for individuals who are currently in high tax brackets because they can take a tax deduction now and instead pay taxes on their withdrawals in retirement when they should be in a lower tax bracket.
Health Savings Account (HSA)
An HSA is another tax-advantaged account available to individuals who have a high-deductible health insurance plan. The minimum annual deductible to qualify for an HSA in 2021 is $1,400 for a self-only plan or $2,800 for a family plan. Like an IRA, funds in an HSA can be invested in numerous securities, and your contributions can grow tax-free. Contributions are tax-deductible, and withdrawals are not taxed if they are used to pay for qualified medical expenses. There are no required minimum distributions at any age, and after age 65, funds can be withdrawn to pay for living expenses, although these withdrawals are taxed as ordinary income. The tax-advantaged nature of the accounts combined with the ability to use funds in retirement without incurring a penalty make HSAs a great vehicle for retirement savings. Unfortunately, the annual contribution limits are rather low. In 2021, you can contribute $3,600 to a self-only HSA or $7,200 to a family HSA. If you are 55 or older, you can contribute an additional $1,000.
General-Purpose Brokerage Account
Another option to save for retirement is with a general-purpose brokerage account. The disadvantage of this account is that it does not provide any tax benefits. There is no tax deduction for contributions, and you will have to pay capital gains tax on your profits. However, there are several advantages provided by this type of account. There are no income restrictions for opening an account, no contribution limits, and you can withdraw your money whenever you want. If you are planning to retire early, then it may make sense to save in a general-purpose brokerage account because you can contribute more and withdraw your money at any time without a penalty.
Just because your employer doesn’t offer a 401(k) doesn’t mean you can’t save for retirement. Depending on your individual circumstances, there are several tax-advantaged options you can use, in addition to an ordinary brokerage account, in order to ensure that you can retire comfortably.