Retirement accounts are some of the best resources people have at their disposal for saving and investing for retirement. The most common type of retirement account is a 401(k), mainly because it's offered through employers. However, it's not the only retirement account.
IRAs can also play a significant role in someone's retirement savings.
Although 401(k)s get most of the attention, IRAs can be just as good a resource and even better in some cases.
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I like to have options
There are pros and cons to virtually everything finance-related. One con of a 401(k) is the limited investment options. In a 401(k) plan, you're generally given a combination of the following to choose from: your company's stock (if it's a public company), market cap-based index funds, target-date funds, and an international fund.
To be fair, you can have a well-rounded retirement portfolio using those options, but they're limiting nonetheless. Those select options might not do the trick for investors who want more freedom to tailor their stocks to better fit their goals and preferences.
If you're a fan of Apple and don't work there, you're only chance to invest in it via your 401(k) would likely be a large-cap index fund. If you want to invest in Alibaba and don't work there, your only option would likely be an international index fund if offered.
IRAs work like brokerage accounts; you can invest in any individual company or exchange-traded fund (ETF) you want. Those Apple and Alibaba shares are only a few clicks or taps away.
Don't overlook how fees add up
A good thing about having more control over your investments is that you also have more control over your fees. A 401(k) generally comes with four types of fees:
- Administrative: Used for accounting, recordkeeping, and various administrative tasks needed to run and maintain your account.
- Investment: Charged by your specific investments, such as ETFs.
- Service: Optional services you may opt into, such as a 401(k) loan.
- Advisor: Charged if you elect to use your provider's advisory services if offered.
With an IRA, you only have to worry about the expense ratios of whatever ETF you may invest in.
Suppose someone invests $500 monthly into a large-cap fund (like the S&P 500) in an IRA and 401(k). If they have 2% worth of 401(k) fees and the large-cap fund has a 0.03% expense ratio, here's roughly how their investments would stack up after 25 years if they averaged 10% annual returns:
| Annual Fees | Ending Value | Amount Paid in Fees |
|---|---|---|
| 2% | $438,600 | $151,400 |
| 0.03% | $587,400 | $2,600 |
Data source: Author calculations, rounded to the nearest hundred.
2% is small on paper. But it's expensive in real life.
More lenient withdrawal rules can pay off
You want to avoid withdrawing money early from your retirement accounts if possible, but sometimes, life happens. Both 401(k)s and IRAs have 10% early withdrawal fees, but there are some shared exceptions, such as disabilities, medical expenses, and certain military personnel.
With an IRA, the number (and type) of exceptions to this early withdrawal fee are much greater. Starting with the ability to take withdrawals for qualified education experiences, like tuition and fees, books, and other required student activity fees, for you, your spouse, or your child.
Qualified first-time homebuyers can also withdraw up to $10,000 from their IRA to use toward purchasing their home.
The sheer number of exceptions to the 10% early withdrawal fee gives IRA owners more leeway in case they need to make an early withdrawal.
Deciding which IRA is right for you
There are two main types of IRAs: Roth and traditional. With a Roth IRA, you contribute after-tax money and take tax-free withdrawals in retirement. With a traditional IRA, there's a chance you can deduct your contributions from your taxable income.
Deciding between the two generally comes down to your current versus projected tax bracket in retirement.
If your current tax bracket is likely lower than what it'll be in retirement, it makes sense to go with the Roth IRA so you can pay taxes now at the lower rate. If you're in your peak earning years — or above the income limit for Roth IRAs — it makes sense to go with a traditional IRA so you can delay your taxes until you're in a lower tax bracket in retirement.
The maximum contribution to an IRA (both Roth and traditional) for the 2023 tax year is $6,500 ($7,500 if you're 50 or older). This relatively low limit means an IRA probably won't be your primary source of retirement income, but it can be a great supplement that can surely come in handy.
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Stefon Walters has positions in Alibaba Group and Apple. The Motley Fool has positions in and recommends Apple. The Motley Fool has a disclosure policy.
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