Your ability to save and invest on your own will probably determine your finances in retirement.
Your main vehicle for retirement savings will likely be a 401(k), along with an IRA or other qualified employer plan.
If your employer offers a 401(k) matching contribution, that's usually the best place to start.
Before IRAs and 401(k) plans, retirement was simpler—all you had to do was put in your time at work, retire and collect your checks. Between the company pension and Social Security, most retirees figured they had it made. And if they'd managed to save a little extra, it was gravy.
These days, that's all changed. For most workers, traditional defined-benefit pension plans that provide a fixed payment on a regular basis are a thing of the past. And few people expect Social Security to provide the majority of what they hope to spend in retirement. As a result, your ability to save and invest on your own will likely determine your financial situation in retirement.
Recognizing the need to save for retirement is the first step. That's followed by prudent retirement planning, which includes figuring out when you'd like to retire, how much you'd like to spend in retirement and how much you need to save and invest now to get there.
You might think your next step would simply be to start saving. But with all the different retirement accounts out there—401(k), 403(b), 457 plans, traditional IRAs, Roth IRAs, regular brokerage accounts and deferred annuities—it can be hard to know which are best for you, and in what combination.
Retirement workhorses: IRAs and 401(k)s
Your main workhorses for retirement savings will likely be an IRA along with a 401(k), 403(b), 457 or other qualified employer plan, depending on what your workplace offers.
If your employer doesn't offer a retirement plan, you can always start by putting money in a traditional IRA or Roth IRA. But if you have access to a 401(k) or other employer plan, and your 401(k) offers a matching contribution, that's usually the best place to start.
For example, let's say you make $115,000 per year. Your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary. In this case, the first $6,900 of savings should go into your 401(k) plan. Why give up free money?
After you fund your tax-advantaged options to the fullest (as shown in the table below), move on to other ways to save for retirement if you're able to. Should you put the rest of your savings into your 401(k)? Or should you consider a traditional IRA or Roth IRA?
|2013 Contribution limits|
|Account||Contribution limit||Catch-up contribution|
|401(k), 403(b) and 457||$17,500||$5,500|
|Traditional IRA and Roth IRA||$5,500||$1,000|
IRA vs. Roth IRA
If you're still able to save more after taking advantage of your employer's 401(k) match limit, here are some possible next steps:
- If you're eligible to make a deductible contribution to a traditional IRA, consider putting your next $5,500 there—especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals. If you can afford to save more after contributing $5,500 to a traditional IRA,1 then continue with your 401(k) up to the maximum allowed.
- 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 next $5,500 into a Roth.2 Contributions come from after-tax dollars and qualified withdrawals are income tax-free. If you're in a higher tax bracket when you make your withdrawals, the Roth would be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes—but a Roth IRA has other advantages.
A Roth IRA doesn't force you to take required minimum distributions at age 70½, as you'd have to do with a qualified employer plan or traditional IRA. That's an advantage in terms of letting your Roth IRA continue to grow tax-deferred in your later years. It could also benefit your heirs, who'd be able take money out income tax-free after you're gone.
Again, if you're able to save more after you put $5,500 in a Roth, continue with your 401(k) until you max it out.
- If you're not eligible for either a deductible contribution to a traditional IRA or a Roth IRA contribution, then just continue with your 401(k) until you've contributed the maximum allowed.
The Roth 401(k)
A Roth 401(k) account works much like a Roth IRA, but there is no income limit to participate, and you are required to take the minimum distributions that would be required from a Traditional IRA beginning at age 70½. There is also a Roth version of the 403(b) plan.
Eligible employees can contribute up to the 2013 contribution limit of $17,500 per individual, plus an additional $5,500 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.
Assuming your employer offers the option, the choice of a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement—not a bad guess given today's relatively low tax brackets and the potential to generate significant portfolio income and retirement distributions from other deferred accounts. If that's the case, then maxing out a Roth 401(k) and then contributing to a Roth IRA, if you’re eligible, might be the way to go.
On the other hand, if you're in a lower bracket when you retire (or, even worse for the Roth, if the current income tax is replaced by a flat tax or consumption tax), then a traditional 401(k) is a better bet. One way to hedge against the unknown is to split your contributions between the traditional option and the Roth option, assuming your employer makes both available.
Example: Maximizing your retirement accounts using 2013 limits
Let's say your salary is $115,000 and your goal is to save 20%, or $23,000.* Your employer matches your 401(k) contributions, up to the first 6% of your salary ($6,900).
- First, put $6,900 in your 401(k).
- Next, put $5,500 in a Roth IRA (since you are not eligible for a deductible contribution to a traditional IRA).
- Finally, put an additional $10,600 in your 401(k).
In this case, you're able to contribute the full $17,500 limit to your 401(k) and the full $5,500 limit to a Roth IRA.
*Assumes you are filing as single or head of household and under 2013 eligibility figures.
If the amount you're able to contribute to an IRA and 401(k) each year is less than the maximum allowed, follow the steps in the example until you reach your personal savings limit (assuming the employer match).
Keep in mind your 401(k) has a distinct advantage: Once you set your savings percentage, you're on "pay yourself first" autopilot. Since you have a greater opportunity to spend money earmarked for your IRA, you need to be more disciplined about saving it.
What if I've maxed out my 401(k) and IRA?
If you've maxed out your 401(k) and whatever IRA option makes the most sense, and you're looking to save more, kudos are in order!
Here's where to go with those extra retirement dollars:
- Regular brokerage account. Additional retirement savings can go right into your brokerage account. Remember, even if you hold retirement assets in both taxable and tax-advantaged accounts, you should consider all your investments as one big portfolio. What's more, you may be able to add value by placing more tax-efficient investments in your taxable accounts and less tax-efficient investments in your tax-advantaged accounts.
- Nondeductible contribution to a traditional IRA. Even if you're covered by an employer plan and you're above the AGI limit for a Roth IRA3 or a deductible contribution to a traditional IRA,4 you can still make a nondeductible contribution to a traditional IRA. Whether you should or not is a tough call. Besides no up-front deduction, any earnings will be taxed as ordinary income when you withdraw them, so a nondeductible IRA contribution isn't an overly compelling choice. The advantage rests solely on the potential for tax-deferred compounding. But you could effectively defer taxes on stocks in your taxable accounts by trading infrequently or buying an index fund. And if you're in a higher tax bracket and you want to hold bonds in your taxable account, you could always buy municipal bonds, which pay income that is free from Federal income taxes.5
- Deferred variable annuities. This option has some similarities to a nondeductible IRA contribution (i.e., no up-front deduction and earnings taxed as ordinary income when withdrawn), with some notable differences:
- Most deferred variable annuities have an optional death benefit, available for an additional cost, allowing your heirs to get at least what you put in, even if your investments lose value (assuming the contract has not been annuitized prior to your death).
- No required minimum distributions to deal with (assuming the annuity is not held within an IRA).
- You have the option to annuitize your balance, which might come in handy if you're looking for a regular monthly check at some point during retirement.
- Some deferred variable annuities also offer a guaranteed lifetime withdrawal benefit (GLWB), for an additional fee, which can guarantee a minimum floor. Please be aware, however, that such GLWBs protect only your income, not your assets, which will deplete with each withdrawal. Your income is guaranteed to continue for life even after your contract value is fully depleted.
Keep in mind that variable annuities typically include additional costs and fees that can make them relatively expensive compared to a traditional portfolio of individual stocks, bonds, and low-cost, no-load mutual funds or exchange-traded funds (ETFs). Additionally, all guarantees are subject to the claims-paying ability of the issuing insurance company.
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 which retirement accounts make the most sense, start filling them up!
1. $6,500 if you’re 50 or older at any time in 2013.
2. $6,500 if you’re 50 or older at any time in 2013.
3. For 2013, you can contribute the maximum to a Roth IRA if your adjusted gross income (AGI) is at or below $112,000 for single filers and $178,000 for married couples filing jointly.
4. A traditional IRA contribution for 2013 is fully deductible for single filers with a modified AGI of $59,000 or below. For married couples filing jointly, the phase-out range for deductibility is between $95,000–$115,000.
5. State and local taxes may apply as well as the Federal Alternative Minimum Tax. Selling a municipal bond prior to maturity could also result in a taxable capital gain.