Sunday, July 29, 2012

How to Effectively Save for Retirement

I've talked about the 401(k) and the IRA separately before, but I thought I'd do a more consolidated post comparing the two.  There are two main types of accounts that you can use to get tax advantages to save for retirement and they each come in two forms.  The two main types of accounts are 401(k)s and IRAs and the two forms are traditional and Roth.

401(k) vs IRA
The difference between an IRA and a 401(k) is that an IRA, or individual retirement account, is an account that you set up and contribute money to on your own whereas a 401(k) is a plan set up with your employer. While there is a specific set of funds to select from for your 401(k) depending on what your employer offers, you can put securities you choose in your IRA.  You have a a $5,000 per year contribution limit for the IRA and a $17,000 contribution limit for your 401(k).  Also, usually your 401(k) comes with contribution matching from your employer up to a certain percentage.

401(k) Matching and Vesting
I was never really sure about what matching was when I first started looking into the 401(k) and it sounded a little unbelievable at first.  I mean, apparently, when you deposit money into this account, you double it because your employer contributes the same amount.  And it is exactly what it sounds like.  Matching is essentially free money to you for your retirement.  Contributing to your 401(k) up to your employer's matching limit is one of the few things no one argues about doing since it seems like common sense.  For example, let's use easy numbers and assume you make $100k every year and your employer matches 5%, everything you contribute to your 401(k) up to $5k will be doubled because your employer will contribute a matching amount.  This means if you put $5k into your 401(k), your total pay would increase to $105k: $95k income and $10k in your 401(k).

There is something known as vesting in regards to matching, however.  Without vesting, once you make your contribution and your employer matches, you could just quit the company and rollover everything into your own IRA.  Instead, you generally have to continue work for the company for a few more years in order to get claim to those contributions form your employer.  For example, if your company has its contributions vest evenly over 5 years, each additional year of work after that contribution will give you access to an additional 20% of the amount your company contributed.  In our example above, if this scenario applied then after the first year, a total of $1k of the $5k your employer contributed would be available after the first year, a total of $2k the second, etc.

Traditional vs Roth
The main difference in traditional vs Roth is when you want to take the tax hit of realizing income.  With a traditional account, you defer the tax hit until you withdraw your money from your account and any contribution into a traditional account will lower your taxable income for that year.  Let's continue with our earlier example and say that the 401(k) you contribute to is a traditional one.  After contributing $5k, you would only pay taxes on the $95k you realize that year.  When you withdraw your money out of your account in retirement, you will pay taxes on that amount.

For a Roth, you contribute after-tax income, meaning you still pay taxes on any contributions upfront, but when you withdraw money from your account in the future, you won't have to pay any taxes.  So in the example above, if you contribute the $5k to a Roth 401(k), you will still have to pay taxes on $100k of income but you don't pay any taxes when you withdraw the money from retirement.

This makes the difference in tax brackets between making contributions and taking distributions the critical part of the decision between Roth vs traditional.  If you expect the U.S. government to raise income taxes to finance our deficit in the future, a Roth may be the better choice.  However, most people expect to be a lower tax bracket when they retire than when they are working which favors the traditional accounts.  There is also some risk of Congress changing the laws around regarding the tax exemptions of Roths, however small they are.

Which should you ultimately pick?
There are specific restrictions on whether or not you can contribute to a specific account depending on your income, but the tax implications tend to favor Roth over traditional.  Wikipedia has a nice matrix comparing the four accounts which you can take a look at to get more details.  Since the contribution limits don't change whether the account is traditional or Roth and Roth contributions are after-tax, you have a higher after-tax contribution limit for Roths.  If you are maxing your contributions, you will benefit more from contributing to a Roth than traditional because you are able effectively to shore away more money.  You generally also want to contribute to your 401(k) because of your employer matching before contributing to your own IRA but after you hit the matching limit, an IRA may be a better choice because of the flexibility of what assets you can hold in it.  When it comes down to it, it may be better to diversify and have several accounts.  It may be a bit of a hassle to keep track of, but you can minimize the impact of the risks regarding tax legislation.  If you do make a decision on a specific set of accounts to have, make sure you do enough research to support your decision because the savings you can generate for yourself in retirement through these vehicles is no small change.

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