Everyone knows saving for retirement should be a priority. It comes somewhere after paying bills and before that vacation in Greece. The challenge has become not whether to save for retirement, but rather where to save. With so many ways to do it — employer-sponsored plans or individual retirement accounts, not to mention pre-tax contributions or after-tax — where’s a conscientious saver to begin?
“Everybody needs to define a [savings] hierarchy for themselves,” says James Sullivan, vice president and financial advisor at Essex Financial in Essex, Connecticut. For some people this may mean taking the tax deduction today through a traditional account. Others may want to “diversify the taxable buckets they have access to in retirement” by adding Roth savings into the mix, he says.
The trick is knowing which savings method offers the most bang for your buck.
[See: 8 Tips for Investing in Your 30s.]
Start by getting your company match. If your employer offers a company match, “take advantage of that benefit,” says Matt Gellene, a Merrill Edge executive in Boston. Contributing at least enough to a 401(k) to get the full employer match takes priority over saving anywhere else.
To determine if you should be making pre-tax or after-tax contributions, Gellene says investors should look to their current and future tax brackets. Pre-tax retirement accounts such as 401(k)s and traditional IRAs may be the best option for investors who expect their tax bracket to be significantly lower in retirement, Gellene says. This way you can take the deduction today and pay taxes at a lower rate when you withdraw the money in retirement. Roth accounts, however, “can be a great option for those who believe they will be in a higher tax bracket in retirement or expect U.S. tax rates to increase significantly,” says Stuart Robertson, president of Capital One Advisors in Seattle.
The problem with this methodology is that it requires knowing what your tax bracket will be in retirement, which could be decades away. “Frankly, we don’t know what the tax code will be next year,” let alone 20 or 30 years from now, Sullivan says. Consequently, to determine if a Roth is right for them, he suggests investors base the decision on their age rather than their tax bracket.
Use a Roth if you are at least 20 years from retirement. A Roth may be the more attractive option for investors who are further away from retirement, Gellene says. This is because “the longer their earnings can grow, the more potential income they may have that is never taxed.”
Sullivan says a good benchmark is 20 years; if you won’t need retirement savings before then, a Roth should be more advantageous. If your employer doesn’t offer a Roth 401(k), you’re better off getting the employer match in a regular 401(k) first before maxing out your Roth IRA, Sullivan says.
If your employer does offer a Roth 401(k), Robertson says to save there and only resort to an IRA after you’ve maximized your Roth 401(k) contributions. He says investors may find the rules for 401(k)s more generous than IRAs for a number of reasons. A 401(k) has higher contribution limits ($18,000 per year versus only $5,500 for an IRA, or $24,000 versus $6,500 for people age 50 and older) and no income restrictions, whereas a Roth IRA may limit your contribution to less than the maximum amount depending on your income. The ability to contribute to a Roth IRA begins phasing out at $118,000 of adjusted gross income for single or head of household filers. Single filers earning more than $133,000 in adjusted gross income per year can’t contribute to a Roth IRA at all. The income limits are higher for married couples filing jointly, but as Roth 401(k)s have no such limit, high earners don’t need to worry about hitting any boundaries.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
Keeping all of your contributions in one account makes managing those assets easier, Robertson says. For example, managing diversification becomes harder the more accounts you have in your portfolio as you have to consider each account’s allocation into your overall analysis.
Employer-sponsored plans have the added benefit of automated contributions. From a practical standpoint, most people are better off having their contributions taken from their paycheck and deposited directly into the 401(k), Sullivan says. It’s much easier to save small amounts throughout the year than to make an end-of-year contribution to an IRA as a lump sum, which is what many people do, he says.
Avoid IRAs if you are concerned about litigation. Employer-sponsored retirement plans may also be the better choice if protecting your assets from a lawsuit is a concern. Employer-sponsored plans are almost always protected from creditors, while IRAs may not be, Sullivan says.
The laws governing the protection of IRA assets vary widely by state. In some states, creditors may be able to claim your IRA assets in a lawsuit or bankruptcy. Sullivan says investors who believe they are at risk of a lawsuit or those in professional fields with a high risk of litigation, such as doctors or attorneys, may want to check with their state to learn if their IRAs would be at risk before contributing to one.
Roll over a 401(k) to an IRA to manage taxes in retirement. Generally speaking, “401(k)s are great for accumulation, but IRAs are much better for funding your retirement,” Sullivan says. With a 401(k), you must go through your employer to take distributions. “Why have your former employer still involved with your finances when you don’t work there anymore?” Sullivan asks. Withdrawals from an IRA, on the other hand, are at your discretion alone.
[See: 9 Dividend ETFs for Reliable Retirement Income.]
IRAs also make it easier to tell if you are taking pre-tax or after-tax dollars when you withdraw. Your pre-tax and after-tax 401(k) contributions are mixed together, and you may not have a choice of which type to withdraw. Some employer plans won’t allow participants to select whether to withdraw pre- or after-tax dollars, or may not allow a partial distribution at all.
For this reason, Sullivan often counsels his clients to roll over a 401(k) to an IRA before beginning to take distributions.
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IRA or 401(k), Roth or Not — Where Should You Save? originally appeared on usnews.com
