Planning for retirement can sometimes become an afterthought, especially when things like planning to buy your first home, starting a family, or funding 529 plans for your children seem to get in the way. Life is complicated and balancing the needs and wants of today with those of tomorrow is difficult.
So what can you do? And more importantly what should you do?
There is always your 401(k) at work, and they have a Roth 401(k) option. Great! Wait, but what about a Roth IRA? Should you be contributing to that instead? What is the difference?
All are very common questions and my goal with this article is to give you an understanding of how all of these things work, so you can make a confident savings decision.
Employer Retirement Plan vs. Individual Retirement Account
The most typical employer sponsored retirement is a 401(k). With a 401(k) you as the employee make contributions through your paycheck. These contributions can either be with pre-tax money, your traditional 401(k), or with after-tax money if you chose to elect the Roth feature in your 401(k).
If you happen to work for a nonprofit or government agency there is a good chance you will have what is called a 403(b) – same basic concept of a 401(k) just with a different name. You should, depending on the plan, also have a Roth feature to elect as well.
Let me stop here – when thinking about Retirement accounts at work, if you see the word “Roth” it means after-tax money is going to be going in the account. Which means all of the money will grow tax free, and when you take the money out in retirement it will all be tax free. Conversely, the traditional retirement account will have your money going in pre-tax, growing tax deferred, and then taxed as ordinary income when you take the money out in retirement.
Individual Retirement Accounts, typically known as IRAs, can come in three forms – Traditional IRA, Roth IRA, and Rollover IRA. Each of these accounts can be held at a brokerage firm and is not tied to your employer in any way. In order to make contributions to IRAs you need to have earned income.
Traditional IRAs are funded with pre-tax money, meaning you put money into the account and then get to deduct the money on your tax return that year. Then the money grows tax deferred and is not taxed until you take the money out in retirement. The problem with this account is if you are a part of an employer sponsored retirement plan this is not an option for you.
Roth IRAs are funded with after-tax money, meaning you make your deposits with money you have already paid taxes on. The funds will then grow tax free and you never pay taxes on the money you withdraw in retirement.
A Rollover IRA is basically a term used to designate the IRA was not funded from contributions, but instead from a rollover from an old retirement plan. So, if you left your job and you transferred your money from the retirement plan into an IRA – you now have a Rollover IRA which can be in the form of a Traditional IRA or a Roth IRA.
So Where Should You Start?
Find the free money! Make sure you are maximizing your company match at work. Some employers offer a match, and some don’t, but it is worth double checking with your Human Resources departmentto find out if they do or not. Once you know what it is maximize it!
Here is an example. If your company matches 100% of the first 3% and then 50% of the next 3% - you should at least be contributing 6%. So if you make $100,000/year and you contribute 6% of your income, $6,000, your company will contribute – 100% of your first 3%, $3,000, and 50% of your next 3%, $1,500. By maximizing your company match you just got an extra $4,500 from your company! Free Money!
Assuming you are maximizing your company match in your employer retirement plan – you may want to consider funding a Roth IRA only if you have the available cash flow and your emergency fund and short term goals are already funded . There are income limits in order to qualify. If you are single you must make less than $117,000 to contribute, and if you are married less than $184,000 to contribute.
To Roth or Not To Roth the 401(k)?
A common recommendation in the past has been if you are young you should be contributing to a Roth 401(k) because you can pay taxes on the money now instead of paying taxes in the future when your tax rates may be higher. Well, this is a good rule of thumb but the decision to save depends on your individual tax situation as well as the tax classification on the majority of your assets.
As you get closer to retirement we always recommend diversifying your assets into the three tax classifications – Taxable, Tax Deferred, and Tax Free.
If you are interested in learning more about what retirement savings vehicle is right for you contact us today! Happy Saving!