The 401(k) and 403(b) plans are the most common retirement savings options employers offer in the United States. It’s often suggested that you should max out the contributions whenever possible to these options, but is that the right approach to take for your finance?1
There isn’t any easy answer to that question. How much you save depends on your current debt, if you have emergency savings available, and other factors.
It is also dependent on what kind of matching plan an employer offers for putting money into the 401(k) or 403(b). If a company matches 5% of a total $100,000 salary when you contribute the same amount, you’re getting an extra $5,000 per year.
That’s why a review of your employment benefits each year with your HR department is helpful. You’ll get a clearer picture of what to expect in this area.
What Is Vesting, and Why Does It Matter?
Employer matches and other benefits sometimes have a vesting process before you get to take full ownership of what is offered.2
Let’s say that your employer offers a 5% match on all 401(k) contributions without a cap. You decide that this benefit is a pretty good deal, so you put away $10,000 this year. That means you’ll get $500 extra to use for your retirement.
When you look at the stipulations, you see that it says the employer match five years to fully vest, with 20% of the contributed amount qualifying annually. That means you’ll only get $100 of the $500 promised match.
If you contribute the same amount for five years, you will end up getting the total amount of the vestment each year through multiple partial vesting options.
An employer match is free money, but you must be careful about the terms that apply. If your benefit hasn’t fully vested, you’ll likely lose it. If you get fired, find a new job, or can’t work for another reason, your 401(k) or 403(b) might not have as much value as anticipated.
What Are the Alternatives to a 401(k) or 403(b) Contribution?
If you’re looking for different ways to save for retirement, a handful of options could be better than a 401(k) or 403(b). Here is a closer look at the best choices for many individuals and households to use.
1. Roth IRA
If you meet the income requirements for a Roth IRA, it makes sense to maximize your contributions to this retirement option each year.3
Although the contributions aren’t tax-deductible, your earnings grow tax-free.
You can also withdraw your contributions to the Roth IRA at any time without taxes or penalties. It’s only your earnings that must remain untouched until you’re 59.5 years old. Even then, you can avoid the withdrawal penalty by using the money for college expenses, a first-time home purchase, or costs related to birth or adoption.
2. Health Savings Account (HSA)
Contributions to an HSA occur on a pre-tax basis. They also provide earnings that are tax-free, which is why it’s an attractive savings option.4
The catch is that the money from a health savings account must be used to reimburse qualifying out-of-pocket medical expenses. You can take care of copays, visits to the dentist, prescription medication, and similar costs.
You will receive a list of the qualifying medical expenses for reimbursement through your HSA when opening it.5
The reimbursements can come out whenever you want. As long as you track your receipts for the year, you can pull cash back when it’s needed.
To qualify for an HSA, you must have a high-deductible health insurance plan. If you take out money for something other than reimbursing a medical expense before the age of 65, an extensive penalty occurs – and you’ll pay taxes on the amount taken.
3. Taxable Accounts
Although this option doesn’t offer tax-free earnings or a tax deduction, the realized appreciation gets taxed at the capital gains rate instead of as income. That means the government takes a lower cut of what you earned.
If you contribute $10,000 to a taxable account and the value grows to $15,000, you’d pay capital gains on the $5,000 increase.
Since there are no rules about earnings or contributions, you get the most flexibility with this option. Whether you need a new kitchen or an extended vacation, no one cares how you use the money.
A Final Thought on Planning for Your Retirement
If you have enough money to max out your contributions to a 401(k) or 403(b), an IRA, and other savings options, it makes sense to do so. Putting away cash now ensures that you can maintain your current lifestyle when it’s time to step away from your career.
Saving for retirement is based on several different individualized factors, including age, goals, lifestyle preferences, and more. It’s important for your money to meet your desires. Whether you want to relax for a month in Cancun, retire early, or pursue a new career as a pro poker player, it makes sense to save in ways that accomplish your goals.
That’s why a 401(k) or a 403(b) doesn’t make sense for everyone.