Saving for Retirement: IRA vs. 401(K)
Charles Schwab Co.
Retirement was simpler when all you had to do was put in your time at work,
retire and collect your check. 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, all that's changed. Traditional defined benefit pension plans
have become a thing of the past for most workers. And few people seriously
expect Social Security to provide the majority of what they hope to spend in
retirement.
In short, our ability to save and invest on our own will likely determine
whether we realize the retirement of our dreams—or just hope to get by
somehow when we're no longer able to work for a living.
Getting started
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.
After all that, 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) or 457 plans at work, traditional IRAs, Roth IRAs, regular brokerage
accounts — 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 you have earned income but 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 also have access to a 401(k) or other employer plan, should you fund
your 401(k), your IRA, or both?
The best choice is to fund your tax-advantage options to the fullest (as
shown in the table) if you're eligible, then move on to other ways to save
for retirement if you're able (more below). But what if you can't afford to
save that much?
| 2005 |
$14,000 |
$4,000 |
| 2006 |
$15,000 |
$5,000 |
| 2005 |
$4,000 |
$500 |
| 2006 |
$4,000 |
$1,000 |
| 2007 |
$4,000 |
$1,000 |
| 2008 |
$5,000 |
$1,000 |
Got a match?
If your 401(k) offers a matching contribution, that's usually the best place
to start. For example, let's say you make $50,000. Your employer matches
your 401(k) contributions dollar-for-dollar up to 6% of your salary, which
for you amounts to $3,000. In this case, the first $3,000 of savings should
go into your 401(k) plan. Why give up free money?
If you're able to save more than your employer will match, should you put
the rest into your 401(k)? Or should you consider a traditional IRA or Roth
IRA?
IRA vs. Roth IRA
Money you put in a traditional IRA is generally tax deductible no
matter how high your adjusted gross income (AGI) might be—unless you're an
active participant in a qualified employer plan such as a 401(k), 403(b) or
457.
In that case, a traditional IRA contribution for 2005 is fully deductible
for single filers with an AGI of $50,000 or below (partially deductible
between $50,000-$60,000). For married filing jointly, the phase-out range
for deductibility is between $70,000-$80,000 ($150,000 limit for the
non-participant spouse of an active participant in a qualified employer
plan, when filing jointly).
Contributions to a Roth IRA are never tax deductible, but qualified
withdrawals are tax-free (unlike withdrawals from traditional IRAs, which
are taxed as ordinary income). For 2005, you can contribute the maximum
$4,000 to a Roth IRA if your AGI is below $95,000 for single filers and
$150,000 for married filing jointly. You can make a partial contribution if
your AGI is between $95,000-$110,000 for singles and $150,000-$160,000 for
married filing jointly.
If you're still able to save more after taking advantage of your employer's
401(k) match limit, here's what you should do next:
- If you're eligible to make a deductible
contribution to a traditional IRA, consider putting your next
$4,000 there—especially if you expect to be in the same or lower
income tax bracket in retirement when you take withdrawals. You're still
getting a pre-tax deduction as you do with your 401(k), but you'll
likely have more investment choices. If you can afford to save more
after contributing $4,000 to a traditional IRA ($4,500 if you’re 50 or
older in 2005), 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 $4,000 into a Roth ($4,500 if you’re 50 or older in 2005). Your
contribution won't be deductible, but qualified withdrawals will be tax
free down the road. 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 $4,000 in a Roth,
continue with your 401(k) until you max it out.
- If you're eligible for neither a
deductible contribution to a traditional IRA nor a Roth IRA
contribution, then just continue with your 401(k) until
you've contributed the maximum allowed.
Coming in 2006: The
Roth 401(k)
In January 2006, the "Roth 401(k)" account (403[b] plans
will also be eligible) goes into effect. It would work much like a regular
Roth—contributions would come from after-tax dollars and qualified
withdrawals would be income tax- free. But there would be no income limit to
participate!
Employees could contribute to either the traditional 401(k) or the Roth
401(k), up to the 2006 contribution limit of $15,000 per individual, plus an
additional $5,000 catch-up contribution for those 50 or older. Also, the
balance from a Roth 401(k) could be rolled over directly into a regular Roth
IRA when you leave the employer. An employer match, if any, would
automatically go into the traditional 401(k) option, regardless of where the
employee contributions are directed.
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 on a Roth 401(k) and then contributing
to a Roth IRA, if 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) would have been 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.
One obstacle to the new Roth 401(k) is the temporary nature of the 2001 Tax
Act, most of which expires after 2010, including the Roth 401(k). So,
companies may be reluctant to implement an employee benefit that might only
last five years. According to Hewitt Associates, about 35% of 200 top
companies surveyed may add the Roth 401(k). Check with your employer.
Your salary is $90,000. Your goal is to save 20%, or $18,000. Your
employer matches your 401(k) contributions, up to the first 6% of your
salary ($5,400).
- First $5,400 to 401(k)
- Next $4,000 to a Roth IRA (not eligible for a deductible
contribution to a traditional IRA)
- Next $8,600 to 401(k)
In this case, you're able to contribute the full $14,000 limit to your
401(k) and the full $4,000 limit to a Roth IRA.
If the amount you're able to contribute to an IRA and 401(k) each year is
less than the maximum allowed, you would follow the order above until you
reached 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 reflecting a single
asset allocation. 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
- Non-deductible contribution to a traditional IRA. Even if
you're covered by an employer plan and you're above the AGI limit for a
Roth IRA or a deductible contribution to a traditional IRA, you can
still make a non-deductible 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
non-deductible IRA contribution isn't an overly compelling choice. The
advantage rests solely on the benefit of 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 are tax free.
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!
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