Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act, a new law governing retirement savings. The SECURE Act may impact investors nearing- or in retirement, new parents, small business owners and employees. For more information about the SECURE Act, please read this article or speak with your financial consultant.
The world has changed for retirees as the number of U.S. workers covered by a defined-benefit pension plan has declined steadily over decades. For many people, the simpler days when you might expect to reach retirement in good standing and start collecting a monthly pension check are gone.
Today, more workers are being asked to participate in and contribute to their own retirement plans. While Social Security is a valuable resource, those with the ability to build a retirement nest egg are unlikely to rely on their Social Security benefits alone for income.
The saving and investing you do while you’re working will likely play a significant role in your financial life in retirement. So it follows that the earlier you get started, the better. The key is to be realistic and build a plan you can follow.
Start by creating a disciplined, prudent savings plan that defines your retirement goals and includes a monthly savings amount. To help understand how much you might need to be putting away, you can use a retirement calculator or get more help by working with a financial planner.
The next step is to figure out where to put those savings.
Retirement workhorses: IRAs and 401(k)s
Generally speaking, most people have two types of accounts available to them:
Workplace retirement accounts, such as 401(k)s, 403(b)s and 457s
- Individual retirement accounts (IRA), including traditional and Roth IRAs
Whether you use one or multiple account types will depend on your work status, what type of plan your workplace offers and your income level. So which accounts, and in what combinations, should you choose?
If you have access to a 401(k) or other employer plan and your employer offers a matching contribution, that’s the best place to start. (While 401(k) plans are for private sector workplaces, 403(b) and 457 plans are comparable and may be offered to employees of educational organizations, non-profits and state and local governments. Some rules differ from 401(k) plans, but key points discussed in this article apply to all three.)
To understand why you’d want to start with your employer’s plan, consider this example: Let’s say you make $100,000 per year and your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary (the average employer match is closer to 3%). In this case, at least the first $6,000 of savings you earmark to retirement should go into your 401(k). You don’t want to give up the free money your employer is offering as a match.
After you fund your 401(k) enough to get the full company match, you can still set aside more money in a tax-advantaged way—including additional contributions into your 401(k) or contributions to a traditional or Roth IRA—up to annual limits (see table below). For most people, if you have a 401(k) through your employer, it’s a good idea to continue to contribute as much as you can afford, or what you calculate you need to reach your retirement savings goals, up to the annual limits.
2019 contribution limits for selected tax-deferred accounts
|Account type||Contribution limit||Additional catch-up contribution for those age 50 and older|
|401(k), 403(b) and 457||$19,000||$6,000|
|Traditional IRA and Roth IRA*||$6,000||$1,000|
*Contribution limits to a Roth IRA are limited by filing status and adjusted gross income.
One of the convenient features of a 401(k) is that it helps you commit to a regular savings amount because it will be deducted automatically from each paycheck. You’re less likely to miss the money because it never shows up in your pocket or bank account in the first place.
Traditional IRA vs. Roth IRA
If you don’t have access to an employer sponsored plan like a 401(k), or if you max out contributions up to the annual limit and want to save even more, here are possible next steps:
- If you’re eligible to make a deductible contribution to a traditional IRA, consider putting as much as the $6,000 limit there—especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals. If you’re age 50 or older, you can save up to $7,000 in 2019 thanks to catch-up contributions. If you or your spouse is covered by a workplace retirement savings plan, the tax deductibility of contributions will be subject to income limits.1
- If you're not eligible to make a deductible contribution to a traditional IRA but you're eligible for a Roth IRA, consider putting your $6,000 into a Roth (or $7,000 including a catch-up contribution). Contributions are made with after-tax dollars, meaning there’s no potential tax deduction in the year of the contribution, but qualified withdrawals are tax-free in retirement so long as you’ve held the account for at least five years and you’re over age 59½. You will only be eligible to contribute to a Roth IRA if your income is below certain limits.2
A number of things have to be weighed to know whether a Roth IRA is your best option. If you expect you might be in a higher tax bracket when you make your withdrawals, the Roth may be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes—but a Roth IRA still has other advantages, including no tax on your accumulated investment earnings.
Also, a Roth IRA doesn’t force you to take annual required minimum distributions (RMDs) starting at age 70½, as you have to do with a 401(k) plan or traditional IRA. That’s an advantage in terms of letting your Roth IRA continue to grow tax-free in later years. It could also benefit your heirs, who’d be able take money out income tax-free after you're gone.
It’s difficult to know what your future tax bracket will be in retirement, and current income tax rates are near post-WWII lows and could rise in the future. So it may make sense to contribute to a Roth IRA. Doing so can provide you with flexibility—think of it as “tax diversification”—around when you draw on the money and if income tax rates rise.
The Roth 401(k)
More and more employers are making a Roth option available in their 401(k) plans. A Roth 401(k) account works much like a Roth IRA, but there is no income limit to prevent participation, and you are subject to RMDs starting at age 70½.
Eligible employees can contribute up to the 2019 contribution limit of $19,000 per individual (plus a $6,000 catch-up contribution for those 50 or older). Also, the balance from a Roth 401(k) can be rolled over directly into a regular Roth IRA when you leave the employer, thereby circumventing RMD rules.
Assuming your employer offers the option, the could make sense if you think your tax bracket will be the same or higher in retirement, or if you want flexibility and diversification in the way distributions from your retirement accounts will be taxed when you reach retirement, as described above. If you’re in a lower bracket when you retire, then a traditional 401(k) may end up being the better choice, depending on your situation.
One way to hedge against uncertainty about future tax rates or your tax situation may be to split your contributions between the traditional option and the Roth option, assuming your employer makes both available. Note that any matching contributions from your employer must always go in a pre-tax account even if you only have a Roth 401(k).
What if I've maxed out my 401(k) and IRA limits?
If you’ve maxed out your 401(k) and IRA options, congratulations. You’re making significant steps to save for retirement.
If you want to save even more, consider a:
- Regular brokerage account: Traditional brokerage accounts don’t offer the advantage of tax-free or tax-deferred investment earnings, but they can be relatively tax efficient if managed smartly. Consider putting your least tax-efficient investments (actively managed mutual funds, REITs, and other securities where income is taxed when earned, for example) in your tax-advantaged retirement accounts and more tax-efficient investments (passively managed funds, exchanged-traded funds, municipal bonds and stocks held for more than one year, for example) in taxable brokerage accounts.
- Nondeductible contribution to a traditional IRA: Even if you’re covered by an employer plan and you’re above the income limit for a Roth IRA or a deductible contribution to a traditional IRA, you could make a nondeductible (after-tax) contribution to a traditional IRA—but whether you should is a tough call.
You won’t receive an up-front deduction, and any earnings will be taxed as ordinary income when you withdraw them. Alternatively, you could make a contribution to a nondeductible IRA and then turnaround and convert that to a Roth IRA. The rules for conversions can be complex, so be sure to speak with the appropriate financial professional before doing a conversion. So, in the end, a regular brokerage account that contains tax-efficient investments may be more efficient.
The advantage of tax-deferral rests primarily on the potential for tax-deferred compounding. But, there are also ways you can invest to delay or defer taxes in taxable brokerage accounts by not trading actively and investing tax-efficiently.
The bottom line
If you haven't begun to save for retirement—or you're saving less than you should—what are you waiting for? Now that you know more about which retirement accounts may make the most sense, it's time to put your savings plan into action.
1For those covered by a workplace retirement plan, traditional IRA contributions are deductible if 2019 adjusted gross income (AGI) is below $74,000 (single filers) or $123,000 (joint filers); if income is near those limits, contributions may be only partially deductible.
2For 2019, you are eligible to contribute to a Roth IRA if your AGI is below $137,000 (single filer) or $203,000 (joint filer); if your income is just below those levels, you may not be eligible to contribute the maximum.