GET SMARTER ABOUT PLANNING FOR RETIREMENT
Maybe retirement seems like it's a million years off and, while important, is not nearly as urgent as all the other things you have going on right now. Or maybe your retirement strategy is to make it big in your career someday so you won't need to worry about money. Even if that's the case, why not give your future self the gift of spending the next few minutes getting up to speed on the topic so you at least know what your options are.
If you've got 1-minute: If you're still pretty far from retirement, a good entry point would be to explore what types of accounts might benefit you, to start thinking about how much you'll need to save, and to figure out where to actually put your savings. If you have accounts all over the place--like that 401(k) that didn't get rolled over when you left your last employer--do yourself a favor and come up with a plan to consolidate your money so it will be easier to track and manage.
If you've got 15-minutes
beyond the 401(k): what types of accounts are out there?
Some of the most notable differences in the different types of retirement accounts out there 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 the table below is broken out. We've also added some notes on the potential benefits and challenges of each type of account. Note that there are other types of retirement accounts out there that aren'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.
Traditional 401(k) | $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, meanings 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 may 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 70.5, 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.
ok, got it. Now what type of account should I be using?
Figure out what you're eligible for
To make this decision, start with something simple and figure out what your options actually are. Does your income exceed the Roth IRA limits which will limits potential tax benefits? Does your employer offer 401(k) matching (free money!!)?
Make some assumptions about taxes
Next consider how the tax advantages of a Traditional 401(k)/IRA (avoid taxes on money you contribute, pay taxes when you withdraw) might compare to the tax advantages of a Roth 401(k)/IRA (pay taxes on money you contribute, avoid taxes when you withdraw) for your personal situation. In general, you'll get the most benefit if you're paying the IRS when your tax rate is the lowest, so the 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. In practice, the right answer for you is probably more nuanced and relies on the assumptions you're making.
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 the 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. There's a calculator below that will help you do so.
Consider how to create options for yourself
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 have to pay taxes on those earnings.
Consider the possibity of diversifying among different types of accounts--shooting for some Traditional, some Roth and some regular taxable investment accounts. Each account offers unique characteristics that can make them worthwhile to have in your toolkit as the future unfolds.
How much do I need to savE?
When it comes to figuring out this question, there's some good and some bad news. The good news here is that there are a lot of calculators out there, some of them quite elegant and user friendly, to help you crunch the numbers. The bad news is that none of them are going to offer you absolute certainty about the future. It's just not possible for them to do so -- the future is inherently uncertain. But don't let that be a convenient excuse for ignoring the topic entirely. Knowing the reality of whether or not you're on track can be scary, even if it is based on a lot of assumptions that could change. But before you decide that ignorance is bliss, consider this: If you are off track, wouldn't you rather know now when you can actually do something about it?
Check out some of the calculators in the Resources section to crunch the numbers. Try using a few of them to get a sense for what a target range for you might be.