When it comes to money planning, most people know saving for retirement is a good idea—but there’s less certainty as to how to get there. While employer-sponsored 401(k) savings programs are a popular option, they’re not available to everyone and may not suit the needs of every individual.
There are a number of 401(k) alternatives for individuals looking to save for retirement. Just like 401(k) plans, each alternative has specific pros and cons that may seal the deal or break the deal for different investors.
The more information an investor has about each of these options, the more likely they are to make a decision that aligns with their goals.
A Quick 401(K) Overview
A 401(k) is an employer-sponsored retirement fund. Contributions are determined by an employee and then drawn directly from their paycheck and deposited into a dedicated fund.
Income tax on 401(k) contributions is deferred until the time that it is withdrawn—usually after retirement—at which point it is taxed as income.
During the time that an employee contributes pre-tax dollars to their 401(k) plan, the contributions are deducted from their taxable income for the year, potentially lowering the amount of income tax they might own. For example, if a person earned a $60,000 annual salary but contributed $6,000 to their 401(k) in a calendar year, they would only pay income tax on $54,000 in earnings.
But there are annual limits on contributions—an individual can’t put away their entire year’s paychecks, for example, and declare an income of $0. The ceilings on contributions change annually, so it’s important to check with a plan administrator or the IRS. In 2022, the deferral limit for traditional 401(k)s is $20,500—a $1000 increase over the 2021 limit (individuals older than 50 can contribute an additional $6,500 in catch-up contributions). If a person participates in multiple 401(k) plans for several employers, they still need to abide by this limit, so it’s a good idea to add up all contributions across plans.
Pros of a 401(k)
A 401(k) can be a helpful savings tool for a variety of reasons.
• It makes saving money automatic. Because withdrawals are set up in advance, and automatically deducted from an individual’s paycheck, it essentially puts retirement savings on “auto-pilot.” An individual doesn’t need to remember to put money aside regularly for retirement or earmark funds from their take-home pay.
• An employee can take advantage of “free money.” Some companies pay into employees’ 401(k)s, whether through matching programs—in which employers contribute an equal amount to the employee’s paycheck deduction, up to a limit—or through non-elective contributions, which occur whether or not the employee makes contributions.
Cons of a 401(k)
There are some drawbacks to the plan that individuals should be aware of.
• Penalties for early withdrawals. When an individual puts money into a 401(k), their ability to use it before retirement is somewhat restricted. Though it may be possible to withdraw money from a 401(k) or take out a 401(k) loan, under most circumstances there is a financial penalty.
• Mandatory fees. Not all 401(k) participants are aware they’re being charged fees on their 401(k) plans. Costs can include plan administration and service fees, as well as investment fees such as sales and management charges. Even small differences in fee percentages can result in a big bite of the amount an individual will have at retirement. As such, it’s helpful to brush up on all the costs associated with an employer’s 401(k) and look into other 401(k) alternatives if it makes sense.
Top 4 Alternatives to Investing in a 401(k)
A Traditional IRA (Individual Retirement Account) is similar to a 401(k) in that contributions aren’t included in an individual’s taxable annual income, but are taxed later on when the money is withdrawn.
As with 401(k)s, early withdrawals from an IRA may be subject to an added 10% penalty (plus income tax on the distribution). However the main difference between an IRA vs. 401(k) is that IRAs give individuals more control than company-sponsored plans—an individual can decide for themselves where to open an IRA account and can exert more control in determining their investment strategy.
Learning how to open an IRA is relatively simple—such accounts are available with a variety of financial services providers, including online banks and brokerages. This flexibility allows individuals to comparison shop, evaluating providers based on criteria such as account fees and other costs.
Once an individual opens an account, they may make contributions up to an annual limit at any time prior to the tax filing deadline. In 2022, the ceiling is $6,000 ($7,000 for individuals older than 50).
There are a few key differences when it comes to a traditional IRA vs. a Roth IRA. To begin with, not everyone qualifies to contribute to a Roth IRA. The upper earnings limit for 2022 is $144,000 for singles, and $214,000 for married joint filers.
Another thing that distinguishes Roth IRAs is that they’re funded with after-tax dollars—meaning that while contributions are not income tax deductible, qualified distributions (typically after retirement) are tax-free. Additionally, while an IRA has required minimum distributions (RMD) rules that state investors must start taking distributions upon turning 72, there are no minimum withdrawals required on Roth IRAs.
Like a Traditional IRA, Roth IRAs carry an annual contribution limit of $6,000 for 2022. Roth IRAs also offer similar flexibility to Traditional IRAs in that individuals can open online IRA accounts with a provider that best suits their needs—whether that means an account that offers more hands-on investing support or one with cheaper fees.
A self-directed IRA can be either a Traditional or Roth IRA. But whereas IRA accounts typically allow for investment in approved stocks, bonds, mutual funds and CDs, self-directed IRAs allow for a much broader set of holdings, including things like real estate, promissory notes, tax lien certificates, and private placement securities. Some self-directed IRAs also permit investment in digital assets such as crypto trading and initial coin offerings.
While having the freedom to make alternative investments may be appealing to some individuals, the Security and Exchange Commission cautions that such ventures may be more vulnerable to fraud than traditional investing products.
The SEC cautions that individuals considering a self-directed IRA should do their homework before investing, taking steps to confirm both the investments and the person or firm selling them are registered. They also advise investors to be cautious of unsolicited offers and any promises of guaranteed returns.
Simplified Employee Pension (SEP) IRA
A SEP (Simplified Employee Pension) IRA follows the same rules as traditional IRAs with one key difference: They are employer-sponsored and allow companies to make contributions on workers’ behalf, up to 25% of the employee’s salary.
Though the proceeds of SEP IRAs are 100% vested with the employee, only the employer contributes to this type of retirement account. To be eligible, the employee must have worked for the company for three out of the last five years.
Because people who are self-employed or own their own companies are eligible to set up SEP IRAs—and can contribute up to a quarter of their salary—this type of account can be an attractive option for those individuals who would like to put away more each year than Traditional or Roth IRAs allow.
With a number of alternatives to 401(k)s to choose from, it’s clear there’s no one right way to save for retirement. There are numerous factors for an investor to consider, including current income, investment interests, and whether it makes sense to invest pre- or after-tax dollars.
Ultimately, the important thing is to identify a good account for one’s individual needs, and then contribute to it regularly.
SoFi Invest® offers a variety of active and automated IRAs with a broad range of investment options, member services, and a robust suite of planning and investment tools.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC Registered Investment Advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“SoFi Securities”).
Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above, please visit https://www.sofi.com/legal/.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.