By ROB WILLIAMS
FEBRUARY 15, 2018
Not too long ago, retirement probably seemed simpler—if your employer offered a pension as part of your retirement plan, when you retired in good standing, you’d start to collect a pension check.
The world today for retirees has changed. Most workers are being asked to participate in and contribute to their own retirement plans, and traditional defined-benefit pension plans are on the decline. While Social Security is a valuable resource, if you’re a saver and investor, you likely don’t expect that Social Security alone will provide the majority of what you hope to spend in retirement.
As a result, your ability to save and invest while you’re working will likely play a significant role in your financial life in retirement.
The first step is recognizing the need to save for retirement. Follow this with a disciplined, prudent retirement plan, starting with monthly savings, if possible. To get into the numbers, you can use a retirement calculator or, even better, a financial plan. But either way, start saving now.
Retirement workhorses: IRAs and 401(k)s
Your main workhorses for retirement savings may be a 401(k), 403(b), 457 or other qualified employer plan along with an IRA or other non-employer account, depending on your employment status and what your workplace offers. Which should you choose?
You can always start by putting money in a traditional IRA or Roth IRA, if your employer doesn’t offer a retirement plan. But if you have access to a 401(k) or other employer plan, and your employer offers a matching contribution, that’s usually the best place to start.
For example: Let’s say you make $100,000 per year. Your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary. In this case, the first $6,000 of savings you earmark to retirement should go into your 401(k) plan. Your employer will add money, up to the employer match, if they offer it. Why give up free money?
After you fund your 401(k) to the match, you can still set aside more money using tax advantaged accounts—including additional contributions into your 401(k) or other employer-sponsored account, or into a traditional or Roth IRA—up to annual limits (as shown in the table below). For most people, if you have a 401(k) through your employer, you should continue to contribute, as much as you can afford or calculate you need to save, up to the annual limit.
One of the convenient features of a 401(k) or other employer-sponsored plan is you commit to a savings rate, then the amount is deducted automatically from each paycheck. This can help keep you from “missing” the money or changing your savings plan.
2018 contribution limits for selected tax-deferred accounts
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 in your 401(k) and want to save more, here are possible next steps:
- If you’re under age 50 and eligible to make a deductible contribution to a traditional IRA, consider putting your first $5,500 there—especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals.¹
- If you’re under age 50 and not eligible to make a deductible contribution to a traditional IRA but you’re eligible for a Roth IRA, consider putting your $5,500 into a Roth.2 Contributions come from after-tax dollars and qualified withdrawals are income tax-free as long as you’ve held the account for at least five years. 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. Individuals 50 and over are eligible to make a $1,000 catch up.
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.
The Roth 401(k)
More and more employers are making a Roth option available to 401(k) plans. 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 are also Roth versions of the 403(b) and 457 plans.
Eligible employees can contribute up to the 2018 contribution limit of $18,500 per individual, plus an additional $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.
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, or if you want flexibility and diversification in the way distributions from your retirement accounts will be taxed when you reach retirement.
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.
What if I’ve maxed out my 401(k) and IRA limits?
If you’ve maxed out your 401(k) and whatever IRA option makes the most sense, congratulations. You’re making significant steps to save for retirement.
Here’s where to go with those extra retirement dollars:
- Regular brokerage account. Additional savings can go directly into brokerage account. While traditional brokerage accounts don’t offer the advantage of “tax-deferral” on investment earnings, remember, many types of investment earnings – such as long- term capital gains on stocks held for more than one year, qualified dividends, and municipal bonds – can also be relatively tax-efficient. Consider tax-efficient investing in “taxable” brokerage accounts if possible.
- 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 IRA3 or a deductible contribution to a traditional IRA,4 you can make a nondeductible (i.e. post-tax) contribution to a traditional IRA. Whether you should or not is a tough call. You receive no up-front deduction. And any earnings will be taxed as ordinary income when you withdraw them. So, in the end, a regular brokerage account, holding tax-efficient investments such as stocks held for the long-term, may be more advantageous in the end. The advantage of tax-deferral rests primarily on the potential for tax-deferred compounding.
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, put your savings plan into action.
1 $6,500 if you’re 50 or older at any time in 2018.
2 $6,500 if you’re 50 or older at any time in 2018.
3 For 2018, you can contribute the maximum to a Roth IRA if your adjusted gross income (AGI) is at or below $120,000 for single filers and $189,000 for married couples filing jointly. You can contribute a reduced amount if your income is more than $120,000 but less than $135,000 for single files and more than $189,000 but less than $199,000 for married couples filing jointly.
4 A traditional IRA contribution for 2018 is fully deductible for single filers who are covered by a retirement plan at work with a modified AGI of $62,000 or below. For married couples filing jointly, the phase-out range for deductibility is between $99,000–$119,000.
Withdrawals prior to age 59 ½ from a qualified plan, IRA may be subject to a 10% federal tax penalty. Withdrawals of earning within the first five years of the initial contribution creating a Roth IRA may also be subject to a 10% federal tax penalty.
The information provided here, as of tax year 2018, is for general informational purposes only, and should not be considered an individualized recommendation or personalized investment, legal, or tax advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Where specific legal, tax, or investment advice is necessary or appropriate, Schwab recommends that you consult with a qualified tax advisor, CPA, financial planner, or investment manager.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk including loss of principal.
Tax‐exempt bonds are not necessarily a suitable investment for all persons. Information related to a security’s tax‐exempt status (federal and in‐state) is obtained from third‐parties and Schwab does not guarantee its accuracy. Tax‐exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer’s plan; rolling over assets to a new employer’s plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.