Limiting your retirement planning to a 401(k) could mean leaving a significant amount of money on the table.
The 401(k) has become synonymous with retirement savings. Considering that over 40% of U.S. workers participate in this retirement strategy, this doesn’t come as a surprise.
Given the right circumstances, a 401(k) can be an extremely effective method of building wealth, but its not a one-size-fits-all approach.
The benefits of a 401(k)
Before discussing alternative vehicles for saving for retirement, it’s worth noting why 401(k)s have grown in popularity.
First, the benefit of an employer match is not to be underestimated. An employer match is when the company you work for matches your contributions dollar for dollar, up to a certain limit. For example, if your employer has a 3% match, they will match 100% of your contributions up to 3% of your salary. This match is literally free money, so you should take advantage of this benefit if given the opportunity.
The other notable advantage to a 401(k) is the contribution limit. Tax-advantaged accounts have limitations on how much you can contribute. The 401(k) has an extremely high annual limit of $22,500, starting in 2023.
If you’re not fortunate enough to receive an employer match, there are some alternative strategies to consider.
Roth IRA
The Roth IRA is essentially the inverse of the 401(k). While a 401(k) allows you to invest pre-tax dollars, Roth IRAs are post-tax accounts. The main advantage of this savings vehicle is it allows you to grow investments tax-free. This is in contrast to the 401(k), where you’re investing pre-tax dollars in hopes of withdrawing the money in retirement in a lower tax bracket.
With a Roth IRA, you’ll have to pay taxes up front, but you’ll never pay taxes on the capital gains you incur. For long-term investors, this is an unbelievable advantage.
While 2023 contributions are limited to $6,500 per year, you can withdraw those initial contributions anytime, without penalty.
Traditional IRA
A traditional IRA is much like the 401(k) in that it’s a pre-tax savings vehicle. The main advantage over the 401(k) is that you have greater freedom in your investment choices. Most 401(k)s limit your investment options to a handful of mutual funds, whereas the traditional IRA allows you to invest in most publicly traded securities and bonds. Some brokers allow you to buy cryptocurrency, as well.
The annual contribution limits for a traditional IRA are significantly lower at $6,500 ($7,500 if you’re over 50), but the plethora of investment options make this a viable alternative to the traditional 401(k), especially in the absence of an employer match.
Health savings account
If you have a high-deductible health plan (HDHP), you might consider contributing to a health savings account (HSA). Check with your insurance provider to determine if yours qualifies.
An HSA allows you to set aside pre-tax money toward healthcare costs. The beauty of this savings account is, if used properly (i.e., on qualified healthcare expenses), you’ll never pay taxes on the contributions or the income they generate.
In other words, as long as you use the money for qualified healthcare expenses, you’ll completely avoid paying taxes on the contributions and any investment returns they generate. While most people tend to think of traditional medical expenses when thinking about the HSA, the qualifying expenses also include everyday items you might pick up at your local pharmacy such as cough drops, contact-lens solution, and even sunscreen.
In some instances, you can even invest your contributions so that you can grow your healthcare savings tax-free. (Important note: you’ll need to check with your HSA administrator to determine if your plan has a minimum balance to begin investing.)
The main drawback of an HSA is the HDHP requirement. Generally speaking, those with lower expected healthcare costs benefit from HDHPs because their monthly premiums are much lower. If you expect to have significant healthcare expenses, an HSA may not be right for you.
Outside of the employer match, the 401(k) lacks appeal
The point of this article is not to demonize the 401(k). It’s an excellent way to build long-term wealth if you receive an employer match. But if you’re not getting that match, you’re essentially contributing to a retirement account with limited investment options with the hope that you’ll be in a lower tax bracket when you withdraw the funds in retirement.
While you might still consider allocating a portion of your savings to this option due to contribution limits, the tax advantages of Roth IRAs and HSAs, along with the optionality of traditional IRAs, offer a more advantageous and robust investment strategy when planning for retirement.
