401(k) plans are powerful tools individuals can use to save and invest for retirement. I would argue that with high individual contribution limits, tax advantages, and employer contributions, a 401(k) is the best tool to save for retirement. In fact, we love 401(k)’s so much as a savings tool we wrote the book on it - Becoming a 401(k) Millionaire (actually Peter Fisher our CEO did).

While 401(k)'s have helped answer the question "How to save for retirement?", they do not answer "How to turn retirement savings into retirement income?". That’s where Individual Retirement Accounts (IRAs) enter the picture. IRAs provide flexibility in retirement that towers above 401(k) plans in three key areas: investment selection, distribution strategy (taking money out), and tax efficiency.

Building an Investment strategy for retirement

Utilizing investment options that align with your retirement goals and needs is important for a successful financial plan. According to Vanguard, the average 401k plan has 27.6 investment options for employees to choose from¹. This is a positive for 401k investors to avoid choice overload, but not always optimal for distributions. Compared to a 401(k), IRAs provide for much greater flexibility on the types of investment options available. The flexibility of investment options in an IRA can help to build a customized investment strategy to align with someone's retirement needs/goals. The shortlist of investments an IRA can hold are Individual Stocks, Mutual Funds, Exchange Traded Funds (ETFs), Bonds, US Treasuries, CDs, and Annuities.

Strategizing Distributions

Saving money in a retirement account is not a means to an end. There is a purpose to it, and for most the goal is retirement. We put money into a retirement account so that we may withdraw it someday when we are no longer receiving a paycheck. When building an efficient distribution strategy, flexibility is key.

While most 401(k) plans can administer distributions in retirement, there is often less control of how the money comes out of your account. As an example, let's assume you have two different investment options inside of your 401(k) account. One investment is geared for growth and the other for conservation (short-term needs).

With a 401(k), there is less flexibility than an IRA when choosing which investment you can choose to sell to take a cash distribution. Let’s say 50% of your 401(k) is in your growth investment and the other 50% is in your conservative. For every $1,000 you take out of your 401k, $500 will come from the sale of your Growth Investment and the other $500 from your conservative investment.

What happens when your growth investment loses 10-20% of its value due to normal market volatility? When you need your next distribution, your 401k will sell both the conservative investment as well as the growth investment (whose value has just decreased). By taking money out of a 401(k) during normal market volatility, you are violating the first rule of investing: buy low, sell high.

If 401(k) distributions are an entrée, an IRA is an a la carte. With an IRA you can choose which investment to sell to fund your distribution needs. If your growth investment has lost some of its value, you don't have to sell. You can use more of your conservative investment while you wait for the market to rebound. While in a good market where your growth investment increases in value by 10-20%, an IRA gives you the flexibility to sell high on your growth investment.

Tax efficiency

If not taken into consideration, taxes can squander someone's retirement account balance. It is important to withhold and pay the correct amount as you take withdrawals from your tax-deferred retirement account. Here is how 401(k)’s and IRA’s differ with regards to tax withholding:

For 401(k) distributions, the IRS requires a mandatory withholding of 20% for Federal Income Tax purposes. The account holder can request more to be withheld federally, but not less. The account holder can also withhold applicable state income tax. For example, say the account holder needs to withdraw $1,000 (net) from their 401(k). The plan provider will make sure there is 20% withheld for federal tax purposes. For every $1,000 needed, the account holder will withdraw $1,250 (The calculation: $1,000 ÷ 0.8 = $1,250). This mandatory withholding can be very convenient. However, what happens if taxes owed in retirement are less than 20%? The extra withholding will likely come back to you as a return once you file taxes. Unfortunately, there may be an opportunity cost. By withdrawing too much, the tax-deferred compounding growth on these dollars is lost.

An IRA provides flexibility to withhold (or not withhold) at a lesser amount to avoid selling unnecessary investments from a retirement account. If the federal tax owed is 11%, 11% can be withheld from the IRA. This saves the account holder 9% or $126 from being withheld, comparing to the 401k example above ($1000 ÷ 0.89 = $1,124). If this account holder withdrawals $1,000 each month, there is an additional $1,512 withheld each year. IRA’s provide a higher level of efficiency with the flexibility in tax withholdings.

Account Type Matters

Which account is right for you in retirement? Well, it depends. If you are you planning to retire earlier than age 59 ½, 401k plans offer some advantages (See "Rule of 55"). For most, however, an IRA makes sense. An IRA can provide superior flexibility to someone in retirement that cannot be matched by company-sponsored retirement plans like 401(k) plans. This is not a knock on 401(k)’s, rather a promotion of the benefits provided by an IRA. Consider the pros and cons of different account types to make sure they match up with your investment goals.

Sources

 1 The Vanguard Group, How America Saves Report - 2025.

---

---

Related Articles

When you pull back the curtain to see what is inside a target-date fund, there are thousands of individual companies. To help visualize some of the top holdings, we created a graph that illustrates the Vanguard Target Retirement 2045 Fund (VTIVX).

Over time, target-date funds adjust their holdings and asset allocation (stocks/bonds/cash) based on your retirement age. But for now, we hope this snapshot clarifies some of the largest companies inside the Vanguard Target Retirement 2045 Fund. 

---

Health Savings Accounts (HSA) made the roster of tax-deferred accounts. For this reason, these accounts can be a favorable component in a financial plan both today and in the future (65+ years old). HSA accounts were first introduced in 2003, and since then, their utilization among employees and employers has grown meaningfully. In order to be eligible to participate in an HSA – an employee must be covered by a High-Deductible Health Plan (HDHP) and not be enrolled in Medicare or other health coverage. Like an employer-sponsored retirement plan, a Health Savings Account offers benefits for both employees and employers. As such, their increased popularity is hardly surprising.

While there are many benefits of HSA accounts, we must also recognize that switching from a PPO plan to an HSA often results in more out-of-pocket medical expenses during the year. Yes, we agree that sounds unappealing. However, there is always more to the story.  

Benefits of HSA accounts to Employees

• The account is portable. Contributions to HSA need not be used in the tax year they are made. Additionally, if an employee changes jobs, the account is still accessible.  

• Health Savings Accounts do not impose income limitations. Unlike IRAs, highly compensated individuals are still eligible to participate in these tax-deferred accounts.

• Health Savings Accounts provide a trifecta of tax savings:

  • Employee contributions are federal-tax deductible.

  • Federal tax on investment earnings is deferred until withdrawal.

  • All withdrawals (including earnings) used to pay for qualified healthcare costs are free from federal taxes regardless of when they are made.

• Dollars contributed to an HSA are both literally and psychologically compartmentalized for medical expenses.

Benefits of HSA accounts to Employers

• The time and money employees spend on healthcare is often more efficient with an HSA. This seems intuitive because unlike an FSA, employees have ‘skin in the game’.

• Employer contributions to their employees’ HSA accounts are exempt from FICA taxes. In 2020, the combined FICA rate is 7.65% which is not insignificant.

• Offering an HSA plan further diversifies the benefit offerings for their employees.

Hierarchy of Retirement Savings

For those with an employer-sponsored retirement plan and an HSA account, there is a hierarchy for where to best save one’s dollars. This hierarchy assumes the employee does not have significant debt and has also created an emergency savings fund.

• First Priority: Take full advantage of the 401k employer match. Free money!

• Second Priority: Maximize your HSA contributes and invest your dollars for the future.

• Final Priority: If you have extra earnings, contribute the maximum to a 401k plan or a Roth IRA.

Here is an example scenario of the three-step hierarchy above:

• Sophia’s employer matches 50% up to 6%. Melissa should contribute 6% to her 401k plan, and her employer will contribute 3%. Free money – check.

• Next, Sophia should maximize her annual HSA contribution. Trifecta of tax savings – check!

• Finally, Sophia can contribute additional funds to her 401k plan to maximize her annual contribution and/or contribute to a Roth IRA.

Withdrawal Rules

There are early withdrawal restrictions for Health Savings Accounts to ensure individuals are using their account for the intended purpose: paying for medical expenses. Specifically, HSA’s incur a 20% penalty and income tax on any amount withdrawn before age 65 that is not used for medical expenses. That said, an HSA account should be opened with the pure objective of saving and paying for inevitable health expenses throughout one’s life.

When you have your inevitable health care expenses, you can also pay out-of-pocket and keep the receipts for tracking your deductible. From a long-term growth and tax perspective, this may be advantageous if you have extra savings in your bank account.  

Investment Strategy

Most HSA accounts have a minimum cash balance required. Once you have saved the minimum cash balance, the additional dollars can be invested. The investment strategy within your HSA account will vary depending on your financial landscape, but often the investment strategy is aligned with your other retirement accounts – like a 401k or an IRA.

Prioritize your health

It is absolutely imperative to acknowledge that HSA dollars should be spent on health and wellbeing as needed. As exciting and opportunistic it is to imagine a future tax-deferred balance, health today must be prioritized. We do not work in the health sector, but at Human Investing we have a team of financial advisors who are committed to ensuring your medical costs are accounted for in a strategic manner.  

---

Related Articles

In Human Terms: What exactly is a 401k?

Don’t you hate it when you’re hanging out with your friends or family and they use a word in the flow of conversation and you have no idea what it means? Well, after meeting with thousands of 401k participants over the years we realize that often times speaking about retirement accounts can turn into one of “those” conversations. That’s why we wanted to start a series of blogs titled In Human Terms. The goal of these posts are simple, to break down financial lingo to its simplest form allowing you to build on your financial vocabulary and create your own glossary.

With that being said, we thought there was no better place to start than asking the question, what exactly is a 401k? Many of us have one today or have utilized a 401k in the past, but there are few who know how it started, what it is, and some simple do’s and don’ts when participating in one.

How it Started

The section of the IRS code that made 401k plans possible was enacted in 1978 and was intended to provide workers with a tax break on their retirement savings. In 1980, the real birth of 401k plans occurred when a benefits consultant took the IRS code and created a simple, tax-advantaged way for employees to save for retirement. From there, different amendments have been made, but 401k plans have turned into the primary tool for Americans to save for retirement.

What it is

Unlike a Defined Benefit plan where the employer promises to pay a defined benefit to retirees who meet certain criteria, 401k plans are a type of Defined Contribution plan, where employees make automatic contributions that are deducted from their paycheck. This money, that is sometimes matched by the employer, is invested at the employees discretion into one or more funds provided within the plan. At a minimum, employees will have the ability to invest in stock, bond, and money market funds. If investments grow over time in employees accounts, the gains are left untaxed on a year-by-year basis until taken out in retirement.

Do’s and Don’ts

Do’s

• If your employer provides a match, take advantage of it. If you do not know what your match is, or if your company offers one, feel free to call us (503.905.3100) right now!

• Put together an investment strategy that makes sense for your time frame and check in about every 6 months. If the words "investment strategy" don't mean anything to you, we can help you make sense of your 401k and creating a strategy. We've found that the most successful strategies come from participants who take time to set up a good plan and stick to it.

• Understand the specifics of your plan. Having a greater understanding of things like vesting schedules, loan provisions, and contribution types, can affect how successfully you invest in your plan and can save you money over time.

Don’ts

• Cash out when you change jobs. Ideally you do not have to cash out a 401k, especially if you are under 59 1/2. The consequences are large. For example imagine you have a $50,000 401k account and you are 40 years old. By cashing out, it’s possible that between the 10% penalty and paying federal and state taxes, your $50,000 becomes $30,000.

• Think of your 401k as a bank. 401k loans can be costly, especially if you leave your company. Before using your 401k for a down payment on a home or to take a trip, give us a call and make sure that there isn't another option.

• Put all of your money in the safest investment option. While not always the case, often times using a money market limits your long-term earning power and puts you in a position where your account is actually losing purchasing power when inflation is included.

Like most things, 401k’s are not perfect. However, if you are looking for an efficient and effective way to save for retirement, they are one of the best tools out there. We look forward to hearing from you soon, if not be on the lookout for the next In Human Terms blog!

---

---

Related articles