Retirement Planning 201

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Before I started this project, my understanding of retirement planning was pretty basic. The general concepts made sense but I never had time to dive into the details. I appreciated that there were big tax advantages associated with different types of retirement accounts and that funding a 401(k), at least up to the point that your employer matches, was generally considered a good idea. I also realized that it’s hugely beneficial to invest  - and to start early - because of how your earnings compound over time. But that was about it.

Lately I’ve been going a bit deeper to figure out if I’m making all the right moves to position my family well for the future. The two big retirement questions that have been on my mind recently are…

  1. Are we saving enough to ensure that we can (at least) continue to fund our current lifestyle for as long as it needs funding?
  2. What financial vehicles should we be using to save for retirement?

On the first question, I have used several of the retirement calculators out there and ultimately built my own Excel model to figure out what we’ll need to sustain our current lifestyle. I highly recommend taking the time to answer this question for yourself. It has been a nagging concern of mine for some time and even just having an informed perspective on this has provided great peace of mind. After all, even if you’re tracking to totally run out of money, isn’t it better to know that now than to find out when you get there?

The rest of this post is dedicated to my second question: what financial vehicles should we be using to save for retirement? Below are the highlights of the research I did to figure out the answer for my family’s situation. As always, if you want to go deeper, I’ve listed the sources I used on the ‘Resources’ page of this blog. [Side note - since the audience on this blog has grown a bit recently, here’s the part where I remind everyone that I’m not a CFP or a CPA, but rather a zealous student of all things finance, an Excel geek, and a designer who believes that navigating your finances should just be easier.]

Q: What are the differences between some of the major types of retirement accounts out there?

Some of the most notable differences are in how you contribute, how the money you contribute gets invested and in what happens when you withdraw that money. So that’s how I broke things down in the table below. The management consultant in me always appreciates weighing the benefits and challenges inherent in any decision, so I’ve included my view of those as well. Note that there are other types of retirement accounts out there that I haven't included, like 403(b) plans offered by public schools or SEP plans targeted at those who are self employed. You can check out the IRS guide to retirement plans if you want to see a more comprehensive list. 

Vehicle CONTRIBUTE INVEST WITHDRAW Benefits Challenges

($18,000 annual contribution limit*)
- You elect to fund this account through your employer before your payroll taxes are taken out. - You can invest in a limited set of funds specified by your employer’s plan.

- Your earnings are tax deferred, meaning you’ll pay taxes on them when you withdraw.
- You pay taxes at the ordinary income tax rate when you withdraw.

- An additional 10% penalty is imposed on withdrawals before age 59.5.
- Money you would have otherwise given to the government in the form of taxes gets automatically invested, its' value compounds over time and then it’s taxed in retirement when you will quite possibly be in a lower tax bracket. - Your investment options are limited and can carry high fees, some of which can be pretty hidden.

- You have to take a required minimum distribution, starting at age 70 ½ or when you retire. If you don’t, you face a 50% excise tax.
Traditional IRA

($5,500 annual contribution limit*)
- You contribute pre-tax money by taking a deduction on your taxes. Your ability to actually claim the deduction though depends on your income, your tax-filing status and whether you can also contribute to a 401(k). - You can invest in a wide variety of investment vehicles. Things like insurance, antiques and a few other options are prohibited, but you have much more flexibility than with a 401(k).

- Your earnings are tax deferred.
- You pay taxes, generally at the ordinary income rate, when you withdraw your money.

- There’s an additional 10% penalty imposed on withdrawal before age 59.5.
- The tax deduction (if you qualify) lowers your tax burden the year you contribute.

- Your investments are sheltered from taxes as they grow and when the government gets its cut at retirement, you might be in a lower tax bracket, depending on your other income.

- You can hold a wide variety of investments.
- Your deduction may be limited if you (or your spouse, if you are married) are covered by a retirement plan at work and your income exceeds certain levels.

- You have to take a required minimum distribution, starting at age 70 ½ or face a 50% excise tax.
Roth IRA

($5,500 contribution limit*)
- You use money you’ve already paid taxes on to fund this account type and the contributions aren’t tax deductible. - You have a broad spectrum of investment options to shelter from taxes as they gain value over time.

- Taxes on anything you earn are deferred and won't be taxed at all, if you meet a few eligibility requirements.
- When you withdraw your money, you don’t pay taxes on your earnings as long as you’ve held the account for >5 years and you’re at least 59 ½ years old.

- You could face a 10% penalty if you withdraw your earnings early.
- The IRS takes its cut up front, so if you earn insane returns on your investments, you should get to keep it all, as long as you make qualified withdrawals.

- You can hold a broad set of investment vehicles.

- There are no minimum distributions required (while you’re alive).
- There are contribution limits depending on your income. (Apparently there’s also a “backdoor” into a Roth IRA if you exceed these limits; however, it may throw up some red flags on your taxes. I included some links to more info in the Resources section).
Roth 401(k)

($18,000 annual contribution limit*)
- You use money you’ve already paid taxes on to fund the account and the contributions aren’t tax deductible.

- Employer matching contributions go to the traditional 401(k), not the Roth 401(k).
- As with the regular 401(k), you are limited to the investment options you have through your employer.

- Similar to a Roth IRA, your investment returns are tax deferred and eligible withdrawals are tax-free.
- Qualified distributions aren't included in your income. Typically you have to be at least 59 ½ years old and have held the account for >5 years for distributions to be considered qualified. - Unlike a Roth IRA, there are no income caps that might limit your ability contribute.

- When you retire and start taking distributions, they won't get counted towards your income which may help you stay out of the higher tax brackets.
- You are required to start taking distributions when you retire or when you turn 70 ½, though it seems that you can rollover to a Roth IRA and avoid this. I haven't thoroughly researched this though.

- Only available for employees of companies that offer them.

*These contribution limits are per category, not per account type ($18,000 total across a Traditional and Roth 401(k) and $5,500 total across Traditional and Roth IRAs for 2015. There are also catch-up contributions that I haven’t listed for people >50 years old.

Q: Ok great, so which type of retirement account is better to invest in?

The more I dug into this, the tougher this question was to answer. Does the pre-tax advantage you get on the front end with a Traditional 401(k)/IRA outweigh the tax advantage you get on the back end with a Roth 401(k)/IRA?

Assessing tax implications is difficult because you have to make so many assumptions. What will your tax status be when you take distributions in the future? Will income tax rates increase over time? In general, you want to pay the IRS its share whenever your tax rate is the lowest, but it’s hard to figure out when that will be.

The general rule of thumb is to contribute to a Roth IRA/401(k) if your taxes are lower now and to contribute to a Traditional IRA/401(k) if your taxes will be lower in retirement. As a thought experiment, I ran some numbers to see how this actually played out. What I found was that the answer is a lot more nuanced. 

For one thing, you have to consider the tiered tax system in the US. Different levels of income are taxed at different rates. So if you’re in the “25% federal tax bracket,” your marginal tax rate, the rate at which your last dollar was taxed, is 25%. But your entire income was not taxed at that rate. Various taxes and credits also phase in and out at certain thresholds. So the combined effects of these two aspects of our tax system mean that identifying the best course of action is not very straightforward. You really need to run the numbers for your specific situation to get a solid answer. 

Another thing to keep in mind is the option value that some of these accounts provide. For instance, even if you ran the numbers and a Traditional IRA edged out a Roth, consider that the Traditional locks you into taking required minimum distributions which could then push you into higher tax brackets in retirement. A Roth is also nice if, at some point, you have an opportunity to invest in something with the potential for outsized returns because you wouldn't ever have to pay taxes on those earnings. 

The ultimate opinion I formed is that, if you can, it’s probably a good bet to diversify among different types of accounts. Shoot for some Traditional, some Roth and some regular taxable investment accounts. They each offer unique characteristics that make them worthwhile to have in your toolkit as the future unfolds. The most important thing to do, however, is to actually set up and fund these accounts. I often find myself worrying so much about making the perfect decision that I actually fail to make any decision at all. And that is definitely not a good strategy!