Tips on Saving for Retirement

Tips on Saving for Retirement

February 28, 2018

When it comes to saving for retirement, one of the most important things you can do is contribute to a retirement account. Whether it be $25, $500, or $1500 per month, getting started and automating the process is a huge first step.

The next step is to identify what type of account to contribute to.

Employer Sponsored Plan vs. Individual Plan

Many people have access to an employer sponsored plan at work, most commonly a 401(k).

This type of account allows you to save money directly from your paycheck into an investment account set up by your employer. These contributions are tax deductible to you. Meaning you don’t pay any income tax now on the amount to put into the account this year.

When you retire and begin taking withdrawals from your account, the amount withdrawn will be taxable.

If you are in a higher tax bracket now than you will be in retirement, this could mean a permanent tax savings.

An IRA, Individual Retirement Account, operates the same way - contributions are tax deductible to you now (assuming you meet the guidelines for deductibility) and taxed when withdrawn in retirement.

So, what’s the difference between the two and how do you decide which one to use?

The main difference is the annual contribution limit set by the IRS, which can change year-to-year. For 2018, you can contribute a maximum of $18,500 to a 401(k) plan (plus an additional $6,000 catch-up if you’re over age 50) while an IRA is limited to $5,500 (plus an additional $1,000 for those over 50).

Another difference is that 401(k) contributions are always tax deductible to you, but IRA contributions are only deductible if you meet the criteria:

  • You are a participant in an employer sponsored plan (e.g. 401(k), 403(b), SIMPLE IRA, etc.) your MAGI, or modified adjusted gross income, is under $101,000 (phase out to $121,000) if MFJ, or $63,000 (phase out to $73,000) if single or head of household
  • Your spouse is a participant in an employer sponsored plan, your MAGI must be under $189,000 (phase out to $199,000)

Planning Tip: You could max out your 401(k) AND make a deductible IRA contribution of up to $5,500 as long as you met the above criteria. Additionally, a non-working spouse can contribute to an IRA as well - this is referred to as a spousal IRA.

What About a Roth 401(k)?

Putting the label “Roth” in front of the 401(k) or IRA serves as a “coding” to tell the IRS how to treat the contributions and withdrawals.

Unlike the Traditional 401(k) and IRA contributions, contributions to a Roth account are NOT tax deductible. However, they are also not taxed AT ALL when withdrawn in retirement.

If you are in a lower tax bracket now than you will be in retirement, contributing to a Roth may mean a permanent tax savings.

The contribution limits are the same whether a Roth or Traditional retirement account – a maximum $18,500 to a Traditional and/or Roth 401(k) ($18,500 in one or the other, $9,250 in each, or any combination of the two totaling no more than $18,500, plus catch-up) and a maximum of $5,500 (plus catch-up) to a Traditional and/or Roth IRA.

Like the IRA, you must meet certain requirements to be able to make a Roth IRA contribution:

  • For MFJ taxpayers, MAGI must be under $189,000 (phase out to $199,000)
  • For single or head of household tax payers, MAGI must be under $120,000 (phase out to $135,000)

Planning Tip: In some cases, if you don’t qualify to make a Roth IRA contribution, you may be able to make a non-deductible contribution to a traditional IRA and then immediately convert it to a Roth IRA (a.k.a. a “back-door” Roth IRA contribution). As long as you do not have any other IRAs, this conversion would not be taxable, since the contribution was not deductible in the first place.

Deciding How to Contribute

Since it’s not always possible to predict whether your marginal tax rate will be lower or higher in retirement, the next consideration is whether or not you need the tax deduction. If it’s financially comfortable for you to maximize your Roth 401(k) or Roth IRA contribution, consider using the Roth - the ultimate benefit is no tax on the withdrawals in retirement. For others, getting the benefit of the tax deduction with the traditional 401(k) and/or IRA is what helps them to make the contribution in the first place. In that case, consider using the traditional, tax-deductible account.

Here’s an example:

Let’s say you think you can afford to put $400 per month into your retirement plan at work, so you tell your employer to contribute $400 to the Roth 401(k), because you want the benefit of the tax-free withdrawals in retirement. When you get your next paycheck, it’s $400 less, and you now have $400 in your Roth 401(k).

Now, if you decided that you wanted to contribute to the traditional 401(k) instead, you would find that your next paycheck wasn’t quite $400 less – if you’re in the 24% marginal tax bracket, you would find that your paycheck was only reduced by about $300, so it only “cost you” about $300 to put $400 in your 401(k). Hmm, you think…. I can actually afford to put more into the 401(k)! So, you figure out that to reduce your paycheck by the $400 you feel comfortable putting into the retirement plan, you can actually put about $525 into the 401(k) each month!

Over time, this increased contribution may result in a larger account at retirement. Though the withdrawals would be taxable, that may be negated by simply having more money to work with (you may essentially have the same buying power as the Roth even after paying taxes!)

While there are many factors to consider, don’t let yourself get bogged down by the choices and the analysis! The important thing here is to take that first step.... because any choice you make is a good one!

One thing is for sure – every dollar you contribute today, to any type of retirement account, is an investment in your future and your future wellbeing. If you haven’t already started, start today. If you’re already contributing, see if you can increase it. This is one of the most important investments you can make.