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IRA, 401(k), 529: What's the Best Tax-Sheltered Account Type for You?

Note: This article is part of Morningstar's Guide to Saving for Retirement. An earlier version appeared on July 6, 2016.

Congress has periodically looked at the idea of simplifying tax-sheltered savings, but for now investors have to wend their way through a dizzying maze of tax-advantaged investment wrappers: multiple types of IRAs, company-retirement plans, and college-savings accounts, each with its own tax treatment, its own set of rules governing who can contribute and how much, and its own policies on distributions. It's all enough to make you wish for the good old days of certificates of deposit and passbook savings accounts.

But giving due care to the wrapper you choose for your investment accounts and maximizing your investments in tax-sheltered vehicles can greatly enhance your take-home return. The longer your investment horizon, the greater the tax savings are apt to be. Here's an overview of the various types of savings vehicles available for your long-term investing assets--especially retirement--including a summary of the types of individuals who will tend to benefit most from each investment vehicle. Note that there's not a single best investment wrapper for any one individual; most savers will hold a combination of these account types during their lifetimes.

Traditional 401(k), 403(b), and 457 Plans

Geared Toward: Retirement saving

Tax Treatment: Pretax contributions; all withdrawals taxed as ordinary income

Tax Benefit: Tax-deferred compounding

Contribution Limit: $18,000 (younger than 50)/$24,000 (older than 50) in 2017

Income Limit: None

Withdrawal Flexibility: Limited. Individuals must pay taxes and a 10% early withdrawal penalty before retirement age unless they meet certain exceptions.

Investment Flexibility: Limited. Employees must typically choose from fixed menus of investment options.

Required Distributions: Yes, at age 70 1/2 unless still working

Pros: Making pretax contributions provides instant gratification; contributing fixed sums at regular intervals ensures discipline; employers may offer matching contributions; plans may provide access to low-expense institutional share classes.

Cons: Choices may be limited and subpar; small plans often feature high administrative costs and/or high-expense investment options.

Best For: Savers who will benefit from built-in discipline and ease of use

Roth 401(k), 403(b) and 457 Plans
Geared Toward: Retirement saving

Tax Treatment: Aftertax contributions; qualified withdrawals tax-free

Tax Benefit: Tax-free compounding; tax-free withdrawals

Contribution Limit: $18,000 (younger than 50); $24,000 (older than 50) in 2017

Income Limit: None

Withdrawal Flexibility: Limited. Individuals must pay taxes and a 10% early withdrawal penalty before retirement age unless they meet certain exceptions.

Investment Flexibility: Limited. Employees must typically choose from fixed menus of investment options.

Required Distributions: Yes, at age 70 1/2, though rolling over proceeds to a Roth IRA can help circumvent required minimum distributions.

Pros: Ability to take tax-free retirement withdrawals; contributing fixed sums at regular intervals ensures discipline; plan may have access to low-expense institutional share classes.

Cons: Choices may be limited and subpar; small plans often feature high administrative costs and/or high-expense investment options.

Best For: Individuals who expect to be in a high tax bracket in retirement or those who aren't sure about future tax benefits but already have substantial assets in traditional IRAs and 401(k)s.

Traditional IRA (Deductible)
Geared Toward:
Retirement saving

Tax Treatment: Contributions are deductible on income-tax return, provided income is below limit; all withdrawals taxed as ordinary income

Tax Benefit: Deductible contributions; tax-deferred compounding

Contribution Limit: $5,500 (younger than 50); $6,500 (older than 50) in 2017

Income Limit: Single filers with modified adjusted gross incomes below $72,000 who are covered by a retirement plan at work can make at least a partially deductible contribution for the 2017 tax year. In 2017, married couples filing jointly who are covered by a retirement plan at work can make at least a partially deductible contribution if their modified adjusted gross incomes are less than $119,000.

Withdrawal Flexibility: Limited. Individuals must pay taxes and a 10% early withdrawal penalty prior to retirement age, except in certain cases.

Investment Flexibility: High. Most investment types can be held inside an IRA, with a few exceptions.

Required Distributions: Yes, at age 70 1/2

Pros: Investors can choose low-cost and best-of-breed investments with limited administrative costs.

Cons: No so-called guardrails on investment choices, unlike 401(k)s; RMDs plus ordinary income tax due on in-retirement distributions can ratchet up in-retirement tax costs.

Best For: People who think their tax bracket today is higher than it is likely to be in retirement.

Traditional IRA (Nondeductible)
Geared Toward: Retirement saving

Tax Treatment: Aftertax contributions; withdrawals of investment earnings taxable at ordinary income tax rate

Tax Benefit: Tax-deferred compounding

Contribution Limit: $5,500 (younger than 50); $6,500 (older than 50) in 2017

Income Limit: None

Withdrawal Flexibility: Medium. Individuals can withdraw nondeductible (that is, aftertax) contributions at any time without taxes or penalty, but early withdrawals of investment earnings will trigger both tax and a penalty. (You can avoid the penalty if your situation fits with one of the exceptions.)

Investment Flexibility: High. Most investment types can be held inside an IRA, with a few exceptions.

Required Distributions: Yes, at age 70 1/2

Pros: Investors can choose low-cost and best-of-breed investments with limited administrative costs; nondeductible IRA can provide an entry point to a Roth IRA via the "backdoor," which entails making a nondeductible traditional IRA contribution and then converting those assets. May be a decent investment wrapper for investors who want to shelter income-producing assets.

Cons: Investing in a tax-savvy manner in a taxable account will tend to offer better long-term tax treatment: Long-term gains from a taxable account are taxed at the investor's lower capital gains rates, whereas withdrawals of investment earnings from a traditional nondeductible IRA are taxed as ordinary income.

Best For: Individuals who cannot contribute directly to a Roth IRA or traditional deductible IRA.

Roth IRA
Geared Toward: Retirement saving

Tax Treatment: Aftertax contributions; tax-free withdrawals in retirement.

Tax Benefit: Tax-free compounding and withdrawals.

Contribution Limit: $5,500 (younger than 50); $6,500 (older than 50) in 2017

Income Limit: Single filers with modified adjusted gross incomes below $133,000 can make at least a partial contribution for 2017. Married couples filing jointly can make at least a partial contribution if their modified adjusted gross incomes are less than $196,000.

Withdrawal Flexibility: Medium. Individuals can withdraw their contributions at any time without taxes or penalty, but early withdrawals of investment earnings may trigger tax and the 10% early withdrawal penalty. (You can avoid the penalty if your situation fits with one of the exceptions.)

Investment Flexibility: High. Most investment types can be held inside an IRA, with a few exceptions.

Required Distributions: No

Pros: Investors can choose low-cost and best-of-breed investments with limited administrative costs; ability to take tax-free withdrawals in retirement reduces in-retirement tax costs; Roth IRAs are among the most tax-friendly for heirs to inherit.

Cons: No guardrails on investment choices; individuals whose tax brackets go down during retirement may have been better off taking the tax break upfront by contributing to a traditional deductible IRA or traditional 401(k).

Best For: Individuals who expect to be in a high tax bracket in retirement or those who aren't sure about future tax benefits but already have substantial assets in traditional IRAs and 401(k)s.

529 College-Savings Plan
Geared Toward: College savings

Tax Treatment: Contributions may receive a state tax break (either a deduction or a credit). Money compounds on a tax-free basis and withdrawals to pay for qualified college expenses are tax-free, too.

Tax Benefit: State tax break; tax-free compounding; tax-free withdrawals.

Contribution Limit: Per IRS guidelines, contributions cannot exceed amount necessary to provide education for beneficiary. Deduction amounts vary by state, and gift tax may apply to very high contribution amounts.

Income Limit: None

Withdrawal Flexibility: Medium. Investors can withdraw contributions at any time without taxes or penalty. Withdrawals of investment earnings must be used for qualified college expenditures or will incur taxes and a 10% penalty. Those withdrawing funds for noncollege expenses may also be required to pay back any state tax deduction they've received on contributions. They can, however, change the beneficiary of a plan, as long as the new beneficiary is a family member of the former beneficiary.

Investment Flexibility: Low. Investors in 529 plans must choose their investments from a preset menu offered by the plan.

Required Distributions: None.

Pros: High allowable contribution amounts, state tax breaks on contributions, and tax-free compounding and withdrawals. The plans reduce the financial-aid impact compared with money held in the student's name.

Cons: States may impose an extra layer of administrative costs, and investment choices may be costly and/or subpar.

Best For: Individuals who are aiming to stash a significant sum for college while also enjoying tax benefits.

Coverdell Education Savings Account
Geared Toward:
Educational savings, including elementary school, high school, or college.

Tax Treatment: Money compounds on a tax-free basis, and withdrawals to pay for qualified educational expenses are tax-free, too.

Tax Benefit: Tax-free compounding; tax-free withdrawals for qualified educational expenses.

Contribution Limit: $2,000 per beneficiary per year.

Income Limit: Single income tax filers with modified adjusted gross incomes of more than $110,000 and married couples filing jointly with incomes greater than $220,000 cannot make contributions to a Coverdell.

Withdrawal Flexibility: Medium. Withdrawals of contributions are tax- and penalty-free. And in contrast with 529 assets, in which withdrawals will incur taxes and a penalty unless used for qualified college expenses, Coverdell assets may be used for elementary and high school expenses, too. You can also change the beneficiary of a plan, as long as the new beneficiary is a family member of the former beneficiary.

Investment Flexibility: Medium. Coverdell ESA investors can, in theory, invest in a broad swath of assets, but not all investment providers offer the accounts.

Required Distributions: Funds must generally be distributed from an account by the time the student reaches age 30, though they may be rolled over into a Coverdell ESA for another eligible family member.

Pros: Ability to use funds for elementary and high school expenses; flexibility to invest in a broad variety of securities, including mutual funds and individual stocks.

Cons: Limited contribution amounts; investment providers may not offer this account type.

Best For: Individuals aiming to invest relatively small sums for education--including elementary, high school, and college--who are seeking more investment flexibility than 529s afford.