When saving for retirement, there are many different strategies and savings vehicles available. The sheer number of options can make it challenging to determine which strategy or vehicle you should use for your specific situation. Let’s start by looking at the two most popular retirement savings vehicles – the 401(k) profit-sharing plan and an individual retirement account (IRA) – and which you should fund first.
The 401(k) is an employer-sponsored retirement savings vehicle that typically allows an employee to defer some of his or her salary into the plan pre-tax. Additionally, gains on your investments inside of the 401(k) are also tax-deferred until the time of distribution. A 401(k) can offer some additional attractive features to consider like a Roth account, after-tax contributions, or the ability to purchase employer securities inside of the plan as an investment option.
In 2019, you can defer up to $19,000 into the plan and an additional $6,000 can be deferred if you’re age 50 or older. During open enrollment, you can typically set your salary deferral amount as a percentage of your salary each pay period or as a set dollar amount.
Most plans today are set up with automatic enrollment. So, when you join a company, you will be automatically enrolled into the 401(k) at a salary deferral percentage of your salary, say at 4 percent. So, if you earn $50,000 a year, you will start in the plan by deferring $2,000 a year.
However, it is important to review the automatic enrollment framework, as 4 percent salary deferral or $2,000 a year might be a lot lower than you want to or should be saving in the plan. Generally, a good rule of thumb is that you should be saving about 10 percent of your salary for retirement each year. This will give you a higher tax deduction, which could also save you money.
Another reason you might want to increase your savings is something called the employer match. Often to receive the full employer match, you need to save more than the minimum automatic enrollment amount.
For instance, a 401(k) plan could have a 100 percent match on the first 3 percent you save and a 50 percent match on the next 3 percent you save. So, to get the full match you need to save at least 6 percent of your salary.
The employer match is often called “free money” because all you need to do to get it is to save in your plan. So, when determining how much you should put in your 401(k) and if you should save anywhere else, start with saving enough in your 401(k) to get the full employer match.
If you don’t have a 401(k), or you want to supplement your retirement savings, you could also consider saving in an IRA. While there are lots of different types of IRAs, the two most commonly used for individual retirement savings are the traditional and the Roth. Both types allow you to save up to $6,000 a year, with an additional $1,000 contribution if you are age 50 or older.
To be able to save in a traditional IRA, you need to be below certain income levels in 2019 if you or your spouse are an active participant in a qualified plan. For 2019, single filers and heads of households have a phase-out range of $64,000 to $74,000 if the person is an active participant that year in an employer-sponsored retirement plan like a 401(k).
For married filing jointly where the individual is an active participant, the phase-out range for MAGI is $103,000 to $123,000. If you are not an active participant but your spouse is an active participant in a plan, the phase-out range for the non-active participant spouse is $193,000 to $203,000.
To save in a Roth IRA, it does not matter if you are an active participant in a qualified retirement plan like a 401(k), you just need to meet the income limits. For 2019, single filers, heads of households and married filing separately have a modified adjusted gross income range for a Roth IRA of $122,000 to $137,000. So, if the income is below $122,000, a full Roth IRA contribution is allowed, and if MAGI is above $137,000, you cannot contribute to a Roth IRA at all.
For married filing jointly, the income phase-out range is $193,000 to $203,000. While you also need to have earned income to put money into an IRA or Roth IRA, after age 70.5 you cannot save in a traditional IRA, even if you have earned income. However, Roth IRAs and 401(k)s have no such limitation after age 70.5.
Remember, a Roth account is after-tax savings but grows tax-free (as long as certain conditions are met). Roth savings tend to be better in years of low taxes, and tax-deferral savings are better in years of high taxes. So when you are early in your career, consider saving in the Roth account. However, it can still be beneficial to diversify you taxes by saving a little bit in a Roth account each year.
Roth 401(k) savings still qualify for the employer match. If your 401(k) does not offer a Roth account, after you save enough to get the employer match in the 401(k), you might want to consider setting up and saving additional amounts in a Roth IRA if you are paying low-income taxes today.
Now that you have some background on the savings options, how do you decide between them?
First, you should save in your 401(k) enough to get the employer match as a starting point. Next, once you have received the full match, it can make sense to look at diversifying your taxes by using a Roth IRA if you meet the income limits. If not, consider saving in your 401(k) Roth, if your employer offers that option. After putting some money in Roth, make sure you max out your 401(k).
Now for others, if you max out your 401(k) first, you might want to consider saving in a traditional IRA or Roth IRA. The $19,000 a year that is allowed for 401(k) salary deferral does not include the other $6,000 you can save combined between a traditional IRA or Roth IRA. IRAs can be used to supplement your 401(k) savings or to help diversify your tax treatment if you don’t have a Roth account in your 401(k).
Another big difference between IRAs and 401(k)s is access to your contributions. In a 401(k), the plan might allow for in-service distributions or loans, but access to your savings is likely somewhat restricted. However, with an IRA or Roth IRA, there is no restriction to access to your contributions, which means you can withdraw the money at any time.
Withdrawals from a 401(k), IRA or even a Roth IRA could result in taxes and penalties. Early withdrawals in IRAs and 401(k)s, typically meaning prior to age 59.5, are subject to ordinary income taxes and a 10 percent penalty unless some exception applies. This is a big discouragement to taking out money early.
With a Roth IRA, the tax treatment is a bit different and a lot more flexible. Roth IRA contributions are post-tax and can be withdrawn at any time without penalty or income taxes. Furthermore, your contributions come out before your earnings with a Roth IRA, allowing you to have tax-free access to your contributions for emergencies and other spending needs. Earnings with a Roth IRA, if withdrawn early, can be subject to income and penalty taxes just like with traditional IRA and 401(k) withdrawals.
Investment choices between IRAs and 401(k)s can also vary significantly. For instance, most 401(k)s have a very restricted set of investment options. Often, you can only buy mutual funds and other selected investments within the 401(k), as opposed to an IRA, where you can pretty much buy any mutual fund, individual security, bond or investment available.
IRAs are also more flexible on allowing annuities, real estate and precious metals to be held as investments. So, if you are looking for unique or other assets that you cannot find in your 401(k), an IRA might be the way to go.
Clearly, the question of IRA or 401(k) has a lot of nuances. The good news is that you can typically use both together and don’t have to pick one over the other. Often, IRAs are where your 401(k) assets end up after you retire, as they are a valuable rollover vehicle. IRAs can also help you add tax diversification, more investment options and more flexible distributions to your plan. However, make sure you don’t miss out on the employer match and higher savings opportunities in the 401(k).
In the end, look at all your options, discuss your retirement savings plan with a professional and utilize all the tax-advantaged opportunities the best you can to meet your goals.
The views of the author of this article do not necessarily represent the views of Gradifi. We make no claims, promises or guarantees about the accuracy, completeness, or adequacy of the information contained here. Readers should consult their own attorneys or other tax or financial advisors to understand the tax, financial and legal consequences of any strategies mentioned in this article.