How to Invest for Retirement When You Don’t Have a 401(k)
The 401(k) is one of the most common retirement accounts, but not everyone has access to one.
They are employer-sponsored retirement plans that your company may provide as a benefit.
If your company doesn’t offer a 401(k), if you’re self-employed, or if you’re not yet eligible for your employer’s 401(k), there are still ways for you to save for retirement.
Use an IRA
Individual retirement accounts are designed to let individuals save for retirement.
Unlike 401(k)s, anyone can open an IRA and contribute money to it, so long as they have earned income.
You can open an IRA at any number of bank or brokerage, and use the account to designate money for retirement savings. In exchange, you get some tax benefits.
There are two main types of IRA: the traditional IRA and the Roth IRA.
Both follow similar rules, but they offer different benefits.
Traditional IRA Vs. Roth IRA
|Traditional IRA||Roth IRA|
|Contributions may be tax-deductible.||Contributions are not tax-deductible.|
|Pay taxes upon withdrawal.||Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth IRA for 5 years and you've reached age 59 1/2.|
|You must be under age 70 1/2 to contribute.||You can contribute at any age.|
|Required minimum distributions (RMDs) are required starting at age 70 1/2.||No RMDs required.|
Traditional IRAs are the more common type of IRA and the one that most people think about when they hear the term IRA.
Like 401(k)s, traditional IRAs are a type of tax-deferred account.
What that means is you can deduct the money you contribute to a traditional IRA. That can save you a lot of money if you contribute a lot.
Consider this example:
You have a taxable income of $50,000 after your deductions. Income between $37,951 and $91,900 is taxed at a rate of 25%. You decide to contribute $5,000 to a traditional IRA before filing your taxes. This reduces your taxable income by $5,000, so you report a taxable income of just $45,000. This saves you $5,000 * 25% = $1,250 on your taxes.
In effect, every dollar you contribute to a traditional IRA only costs you 75 cents.
That benefit isn’t given to you for free, however.
When you reach 59½, you’re allowed to start making withdrawals from your IRA. When you do make withdrawals from a traditional IRA, you are taxed on the withdrawals as though they were income.
In effect, you delay paying the income tax you owe until you withdraw the money from your IRA.
This is generally a good deal because tax rates are based on your annual income.
Most people are in a higher tax bracket when they are working than when they are retired. In that case, you’ll pay less tax overall.
Unlike traditional IRAs, which provide upfront tax savings, Roth IRAs offer deferred tax savings.
When you contribute money to a Roth IRA, you have to pay the income tax on the contributions. You are not allowed to deduct contributions from your income when filing taxes.
However, when you withdraw money from your Roth IRA, you don’t have to pay any taxes on the withdrawals.
Every dollar in your Roth IRA is a dollar you can pull out of the account and spend.
Another benefit of Roth IRAs is that they allow you to withdraw your contributions from the account without penalty.
With a traditional IRA, you have to pay a tax penalty if you make withdrawals before you turn 59½.
With a Roth IRA, that penalty is only assessed on withdrawals of earnings, not contributions.
This makes Roth IRAs more flexible since you can get the money out of the account if you need to.
The best time to use a Roth IRA is when you have a low income and expect to be in a higher tax bracket when you retire.
This will let you take advantage of your low tax bracket to get tax-free earnings in the future.
Similarities between traditional and Roth IRAs
Other than the specifics of the tax benefits they offer, traditional and Roth IRAs are quite alike.
You are allowed to contribute a maximum of $5,500 to IRAs each year. If you are at least 50, you can contribute an extra $1,000 each year.
This limit is shared by both types of account.
You can’t contribute $5,500 to a traditional IRA and $5,500 to a Roth IRA. You can contribute $3,000 to a traditional IRA and $2,500 to a Roth IRA.
Once you contribute money to an IRA, it is committed to the account. You are not allowed to make withdrawals until you turn 59½.
If you do need to make withdrawals before then, you will have to pay a 10% penalty on the amount withdrawn.
With a traditional IRA, you’ll also have to pay income tax on whatever amount you withdraw.
The exception is that you can withdraw Roth IRA contributions at any time, without penalty. Roth IRA earnings are still subject to the penalty.
The deadline to contribute to IRAs is the due date for that year’s tax return.
If you don’t use all of your IRA contribution space each year, the remaining amount does not roll over. Instead, that tax-advantaged space is gone forever.
Because you can’t get the tax-advantaged space back, contributing as much as possible to your IRAs is important.
Keep the Saver’s Credit in mind
If you have a low income, contributing to an IRA could help you qualify for the lucrative Saver’s Credit.
This credit could give you as much as $1,000 back on your taxes.
The Saver’s Credit will offer you a credit equal to a percentage of your retirement account contributions, on up to $2,000 in contributions.
The percentage match is based on your Adjusted Gross Income (AGI).
This table shows the income limits for each level of the Saver’s Credit for 2018.
Saver's Credit Income Limits
|Credit Amount||Married Filing Jointly||Head of Household||Other Filers|
|50% of contribution||No more than $38,000||No more than $28,500||No more than $19,000|
|20% of contribution||$38,001 - $41,000||$28,501 - $30,750||$19,001 - $20,500|
|10% of contribution||$41,001 - $63,000||$30,751 - $47,250||$20,501 - $31,500|
To illustrate, if you are a single person with an AGI of $20,000, and you contribute $2,000 to a retirement account, you’ll get a $400 tax credit.
If your AGI was $18,000, your credit would be $1,000. If your AGI was $25,000, the credit would be $200.
You can get the credit for either traditional or Roth IRA contributions. Just keep in mind that traditional IRA contributions reduce your AGI.
If you can change what income range you fall into by contributing to a traditional IRA, you can get a bigger credit and save a lot on your taxes.
Taxable Brokerage Account
If you’re able to max out your IRA, the next best way to save for retirement is in a taxable brokerage account.
You can use a brokerage account to invest in stocks, bonds, and mutual funds.
Many brokerages offer target retirement date funds.
With these funds, you choose the fund with a target date nearest the year that you hope to retire. As you get older, these funds will change their asset allocation, moving money out of risky stocks and into less volatile bonds. They give you an all-in-one investment product that you don’t have to think about.
If you’re comfortable with investing, you can instead choose to manage your money yourself.
The benefit of a brokerage account, unlike a 401(k) is that what you’re allowed to invest in is not limited by your employer.
The downside, of course, is that the money in the account was taxed when you earned it.
You also have to pay taxes on the earnings. If you receive a dividend or sell an investment, you’ll owe taxes.
That can slow down the growth of your nest egg.
Don’t Forget About Your Emergency Fund
When you’re thinking about saving for retirement, don’t forget about building an emergency fund.
In fact, building an emergency fund should be your first priority.
Contributing to an IRA or investing in a brokerage account is good, but the money you invest can be hard to get out of the account. If you need quick cash in an emergency, you’ll be happy you have an emergency fund.
Common rules of thumb say you should have between 3 to 6 months’ expenses in your emergency fund.
Ideal Size of an Emergency Fund
|To start...||Ideal goal...||Super safe...|
|$1,000||3-6 months of essential expenses||12 months of expenses|
By keeping that much cash on hand, you should be able to handle any large expense that might crop up. It also provides a good buffer in the event of unexpected unemployment.
If you find yourself with a large bill and don’t have a sufficient emergency fund, you might be forced to take on debt, further increasing the cost of the bill.
Though you might feel like you’re losing out on investment gains by not investing your emergency fund, what you’re really doing is saving money by avoiding expensive debt.
Keep your emergency fund in an online savings account. They charge the lowest fees and pay the most interest out of savings accounts.
401(k)s are a great way to save for retirement, but not everyone can use them.
IRAs and taxable investment accounts are good alternatives if you don’t have access to a 401(k).