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What to Do If You Don't Have a 401(k)

Evaluating the best options for tax-efficient--and automatic--savings outside of a company retirement plan.

It's the elephant in the room in the discussion about whether there's a retirement crisis in the United States: Even though pensions in the private sector are ebbing away and Americans are increasingly responsible for saving for their own retirements, about half of workers don't have access to a retirement plan at work.

That means that even as 50% of workers can take advantage of automatic payroll deductions and contribute nearly $20,000 to a tax-advantaged company retirement plan, about the same percentage is on the outside looking in.

Some of these workers may be employed by companies that offer plans, but they’re not eligible to contribute because they’re part-time or don’t meet other criteria. Some may be self-employed, in which case they have other options for tax-sheltered retirement savings. Others may simply work for a firm that doesn’t field a plan at all.

What are the options for retirement savings in this situation?

Here’s an overview.

1) Invest in an IRA. A good first stop for any worker who has earned income (that is, income from a job and not from investments or Social Security) is to simply fund an IRA to the maximum--$6,000 for investors under age 50 and $7,000 for those over 50. Such accounts are very easy to set up, and the money can be invested in a huge array of options.

Contributing to an IRA can provide a terrific building block for retirement security. A person assiduously investing $6,000 a year in an IRA for 40 years who enjoyed 6% growth on her money would have a little over $920,000 at the end of the period.

Traditional IRAs offer a tax deduction for investors who fall below certain income thresholds, but Roth IRAs offer quite attractive features, too: no taxes on qualified withdrawals and no required minimum distributions in retirement (for now, at least). A Roth IRA can be especially appealing for workers just starting out, in that they can withdraw their contributions (not investment earnings) at any time and for any reason without paying taxes or a penalty. Thus, the wrapper can be a good one for multitasking--both saving short-term reserves for emergency expenses as well as investing for retirement.

Roth IRAs carry income limits on contributions, but anyone can contribute to a traditional IRA and then convert to a Roth via the “backdoor.” Just be careful to mind the tax implications of doing so if you have substantial traditional IRA assets that have never been taxed--rollover IRA assets, for example.

2) Assess whether self-employment accounts are an option. For people who are self-employed, there are a host of options for tax-advantaged retirement savings. Some of them are quite similar to what 401(k) investors have, except that there can be setup costs and oversight responsibilities.

An investment in a conventional IRA, discussed above, should still be the first stop for most self-employed workers. Contributions to an IRA don’t affect your ability to contribute to other types of retirement vehicles for self-employed individuals.

Individual (or Solo) 401(k)s are attractive because they offer both high contributions and a Roth option. Moreover, administrative costs have come down significantly at some of the big providers in recent years.

SEP and SIMPLE IRAs are similar to traditional IRAs. As with traditional IRAs, your money grows on a tax-deferred basis as long as it stays inside the account, and you get to select the investments. Only employers (including self-employed individuals) can contribute to a SEP IRA. With SEP IRAs, self-employed individuals can contribute up to $57,000 or 25% of the employee’s salary, whichever is less. In 2020, the contribution limit for SIMPLE IRAs is $13,500, plus an additional catch-up contribution available for people over age 50.

3) Assess whether an HSA is an option. While by no means a first line of defense for people without a 401(k), a health savings account is a decent ancillary retirement account option for people covered by a high-deductible healthcare plan. If the HSA owner has the wherewithal to use non-HSA expenses to fund healthcare costs as they're incurred, the assets in the HSA can be invested in long-term securities to grow for retirement. And HSAs feature the best tax treatment of any tax-sheltered investment vehicle: Contributions are tax-deductible, investment earnings compound on a tax-free basis, and withdrawals for qualifying healthcare expenses are also tax-free. In a worst-case scenario when someone puts more into an HSA than is needed for healthcare expenses, withdrawals for non-HSA expenditures after age 65 are taxed at ordinary income tax rates but circumvent the 10% penalty that normally applies.

4) Invest in a tax-efficient way in a taxable brokerage account. While it's ideal to invest in vehicles that provide some type of a tax benefit, people without a company retirement plan can also invest pretty tax-efficiently inside of a taxable account. The key is to select investments that incur few taxes on an ongoing basis. From that standpoint, exchange-traded funds are the gold standard for stock exposure, but traditional stock index funds are generally quite tax-efficient, too. Tax-managed mutual funds can also make sense; Vanguard Tax-Managed Balanced VTMFX has long been one of my favorite options for the taxable accounts of hands-off investors. I've also developed several model portfolios for retirement savers who are using taxable accounts rather than tax-sheltered vehicles for their retirement accounts. The key for ensuring that taxable accounts remain tax-efficient, in addition to making smart investment selections to begin with, is to limit your own trading, which in turn limits taxable capital gains.

5) Emulate the best aspects of 401(k)s. For all of these accounts, investors should emulate the good features that come along with investing in a 401(k).

That means taking advantage of the "autopilot" effect that can be such a powerful source of accumulation for people in 401(k) plans. Rather than dumping the money into one of these accounts before the deadline each year, contributing fixed sums at regular intervals will help ensure disciplined savings. It can also help minimize regret, because there's no risk of putting all the money to work at what turns out to be a bad time.

In addition, take note of the fact that 401(k) lineups are usually pretty utilitarian; you could even call them boring. But that's by design: More narrowly focused investments might be tempting, but core stock and bond funds provide broadly diversified market exposure and tend not to experience such extreme highs and lows. Target-date funds can also serve investors well in this context, taking decisions like asset allocation and asset-allocation maintenance off their plates.

6) Be part of the solution. Finally, if you work for a small employer that lacks a company retirement plan, consider offering to assist your employer in figuring out how to get one off the ground. Setting up such a plan has gotten cheaper and less complicated in recent years, and your employer may welcome a financially savvy partner to help with some of the research and vetting. Just bear in mind that small plans don't benefit as much from economies of scale as larger ones do, so it's important to keep a close eye on costs at every level.

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