Which Retirement Plan is Best for Me?
There are many options available to American retirement savers. Since they all operate uniquely and have different benefits, some may be more beneficial than others. Knowing how to prioritize how you save in these accounts could make an enormous difference to your net worth over time.
We cover the use of tax-advantaged accounts in Milestone 5 of The Next Dollar Roadmap.
Naturally, the tax-saving benefits provided through these accounts tend to make them a more optimal choice over those that don’t.
If you already knew that then you may also know that there are several tax-advantaged savings options.
Through employers, 401(k), 403(b), and 457 retirement plans all act as a similar location for tax savings depending on which ones are available to you.
Additionally, you may or may not have a Health Savings Account (HSA) through your employer. It’s also possible to have an HSA from the open market, but the annual contribution is per person or family, not per account.
Outside of employment, IRAs act as the most common private tax-advantaged savings vehicle.
In all likelihood, you have more than one option for saving and may wonder which one would be best for you.
In some ways the availability of these accounts is like being dealt a hand in a game of cards. You may not have control over what you have access to, but you still want to play the hand as wisely as possible.
While we can’t provide a specific answer on the strategy that’s best for you, we can walk through several common scenarios and how someone might prioritize these accounts in order to produce the greatest long-term benefit.
Disclaimers
As we walk through these scenarios below, we want to point out a couple of intentional omissions:
- This is not advice. It is general information. Hopefully, it will help you understand what options are best for you, but we’re not making any recommendations about how you, specifically, should invest. We never would do that through a website.
- We’re not going to wade into the Traditional vs. Roth debate in this post. It’s not that we don’t think it’s important, but we’ve covered it before in more than one place.
- We’re not including college savings plans in this post. Yes, they can provide certain tax advantages, but saving for your kid’s education is less of a priority than saving for yourself no matter what stage you’re in.
If your retirement is in good shape and you really want to help your kids through school, you may choose to fund a college savings plan ahead of filling up a retirement savings option but we won’t cover that here.
We have listed these in order of their potential value to you as a saver, but as you’ll quickly see, the best options depend on your personal circumstances.
1) The Employer Match
“An employer match is not a tax-advantaged savings account, Curt.”
No, it is not.
But the availability of an employer match is the most valuable wealth-building tool commonly obtainable today, and they are overwhelmingly available through tax-advantaged savings accounts.
Around 98% of employers who provide a 401(k) retirement plan provide some form of match, either based on contribution or some profit-sharing percentage.
Around 65% of those who offer a match do so with a dollar-for-dollar contribution.
That’s a return of 100% in case you need help with the math. You can’t just find that sort of investment boost anywhere else.
Matching is most commonly found with 401(k) retirement plans but is also available from the Thrift Savings Plan (TSP), 457 retirement plans, 403b retirement plans, and even Health Savings Accounts (HSAs).
Any opportunity you have to obtain a free employer matching contribution is going to be more valuable than an account that has no such option.
This is probably true even in the case of profit-sharing accounts.
While they may not match at 100%, any money contributed on your behalf is still free for you and probably overshadows even high management costs from an expensive retirement plan.
So, at the top of our list, go get the maximum employer match first, but once you’ve maximized the available matching portion, move on to the next section below.
For example, assume your employer matches the first 3% of your income that you contribute to your 401(k) at 100% and will match 50% up to the next 2% of your salary you save.
In this case, contribute 5% to the 401(k), get 4% total from your employer, and move on to the next option.
If I had multiple matching options, I’d prioritize them as follows:
- HSAs – Some employers will match employee contributions to HSAs. Mine does and it’s awesome. We’ve ranked HSAs ahead of other retirement plans because they receive triple-tax savings (or better) which means they’ll save you even more if used for qualified health expenses.
Remember also that HSAs work like a Traditional 401(k) or IRA once you turn 65. You will lose the income tax benefit on the withdrawal, but your contributions will have grown tax-deferred for years.
- 457 retirement plans – Assuming your 457 provides a match, max this out next because 457 retirement plans provide exceptional withdrawal flexibility if you retire early.
- 401(k), 403(b), TSP, and SIMPLE IRA – Next, take the maximum match from these accounts. There are some subtle differences, but the governance of these three accounts is very similar. If you have access to more than one of these and the matching options are equal, go with the account that has the lowest fees first, then choose the one with the best variety of investment options.
2) Health Savings Accounts
If you do not have any employer matching options available or you’ve exhausted them and need a place to save your next dollar, take a look at an HSA.
As we mentioned above, HSAs enjoy triple-tax advantaged savings when used for qualified medical expenses.
That means the money you put into the account goes in untaxed, it grows untaxed, and when you withdraw your money, it isn’t taxed then either.
And if you make deposits directly from your paycheck into an employer retirement plan, you get to avoid paying social security (6.2%), Medicare (1.45%), and federal unemployment taxes too (6% of the first $7k of income).
“But what if I don’t use that money for medical expenses?”
In that case, the HSA acts like a Traditional 401(k) or IRA. The contributions and earnings have remained tax-deferred, but unqualified withdrawals are made at regular income tax rates.
So, you get plenty of potential upside with an HSA, without losing any of the benefits associated with other traditional retirement options.
You are limited to a maximum annual HSA contribution of $3,850 for individuals and $7,750 for families in 2023. You also must be enrolled in a High Deductible Health Plan (HDHP) to be eligible to make contributions.
For more on HSAs, read this post.
One word of caution with HSAs; your spouse can inherit them without any tax implications, but anyone else will owe income tax on the entire HSA balance in the year it is inherited.
This means your heirs would probably prefer that you use your HSA funds prior to other retirement accounts with easier inheritance rules, but this only matters if you care about their taxes.
3) 457 Retirement plans
Once you’ve exhausted the previous options and are still looking for a place to save wisely, 457 retirement plans are a great direction to go next.
The IRS rules governing 457 retirement plans are very similar to that of 401(k), 403(b), and TSP plans.
The key difference is the withdrawal age for 457s.
In the case of other retirement plans, you’ll have to wait until age 59.5 to make qualified withdrawals (though there are exceptions).
But with a 457, you can begin making qualified withdrawals beginning upon retirement, regardless of your age.
In this way, 457s provide all the other benefits of similar retirement plans but come with much better withdrawal flexibility.
So, if early retirement is in your plans this makes 457s a very appealing next option for tax-advantaged saving.
4) Individual Retirement Accounts (IRAs)
IRAs have gone largely ignored up to this point because there are no matching incentives available to IRA owners (with the exception of SIMPLE plans).
One thing IRAs do offer is exceptional investment flexibility.
There are scores of investment banks and companies that offer IRA accounts of various shapes and sizes, but in most cases, the account owner has complete control over their investment selections.
In a typical retirement account like a 401(k) or TSP, one could be limited to the investment options made available by the employer sponsoring the retirement plan.
This could make investment diversification difficult, resulting in an investment allocation overweighted in a given category leading to higher portfolio risk.
It could also mean the account itself and/or your only investment options have higher expenses than their peers.
Higher expenses erode earnings leading to a reduction in overall portfolio value.
Thankfully, IRAs provide complete control to investors, allowing them to diversify and control costs as they see fit.
This may not seem like much of an advantage on the surface, but over time higher flexibility will produce greater benefits to the investor.
5) 401(k), 403(b), and TSP Retirement plans
Next on the list are three very common tax-advantaged retirement plans that, despite having unique names, operate very similarly.
So similarly in fact that we’ve lumped them together at #5.
All three of these accounts enjoy either tax-deferred or tax-free growth, depending on whether you decide to use Roth or Traditional options.
These retirement plans usually have a sufficient variety of investment options and relatively low costs and can even be better than IRAs in some cases.
Even though they’re showing up late on our list, don’t underestimate their value. They still provide tons of space (up to $72,500 annually in 2023) for retirement saving in a tax-sheltered envelope.
If you haven’t saved 15%-25% of your gross income in the previous steps, finish up your saving here to shore up a secure retirement.
6) Taxable Accounts
You might wonder why I’m listing a taxable account with other tax-advantaged options.
Although taxable brokerage accounts do not enjoy the level of tax-advantaged protection as the preceding options we mentioned, they can still be considered tax-advantaged.
That’s because long-term capital gains in these accounts are taxed at lower rates (0%, 15%, and 20% depending on your income) than your marginal income tax bracket.
Regardless of which income tax bracket you fall in, the capital gains bracket for the same level of income will be lower giving you another tax-advantaged option.
For example, let’s say you’re blessed with an annual taxable household income of $500,000. That puts you in the 35% marginal tax bracket for 2023.
It also puts you in the 15% long-term capital gains tax bracket.
As a result, the income from long-term gains you realize from your taxable brokerage account is taxed 20% less than income from your job.
This is an especially nice option to have as you near retirement and want to consider Roth conversions or other tax-efficient strategies that require flexibility from multiple income sources.
Our Savings Strategy
I’ve said from the outset that I can’t give specific advice through this post, but I’ll share our strategy for annual tax-advantaged savings so you have an example to see.
- First, I (Curt) get about $2,000 annually in my HSA for participating in an HDHP whether I put a dollar in the HSA or not. We do contribute to the HSA, but we’ll get to that in a minute.
- Next, Lisa and I both receive a match on up to 6% of our income in our employer-sponsored 401(k) retirement plans. Not all of it is a dollar-for-dollar match, but it’s pretty close.
- After the 401(k)s, we prioritize IRAs as our income allows for Roth or Traditional contributions. We use an investment company known for having a plethora of index funds to choose from, all with very low expense ratios.
- After the IRAs, it’s back to the 401(k)s for us where we contribute enough to reach our annual 15%-25% savings goal.
- Finally, any remaining savings go into taxable brokerage accounts where we own yet more index funds and ETFs. We also do most of our charitable giving from this account which saves even more on taxes.
We do not have access to 457, 403b, TSP, or SIMPLE retirement plans, so those are off the table, but we’d use them per the list above if we did.
Conclusion
Hopefully, you’ve given some thought about exactly where you are putting your retirement savings already and this can serve as a bit of a sanity check to challenge your choices.
Or maybe you haven’t thought about it at all and this can serve as a roadmap for you.
Either way, don’t underestimate the importance of efficiently making elections where you save. It can make an enormous difference in your overall net worth over the course of your working life.
