Americans are fortunate to have many options for retirement saving. At the same time, the wide variety of retirement account types can be overwhelming: 401(k) or IRA? Traditional IRA or Roth? This article is not a comprehensive playbook for retirement saving options. Rather, we hope it provides readers with an easy way of prioritizing their options, based on their unique opportunities and goals.
Retirement account options can be measured several ways. We think four of the most important to consider are:
- Income Deferral
- Contribution Limitations
- Employer Incentives
Broadly speaking, company sponsored retirement accounts offer the best opportunity to defer income tax due on money that you contribute. This includes 401(k), 403(b), SIMPLE IRAs and SEP IRAs. The annual deferral limits vary between account types and change from year to year, but each of these allow participants to add money on a pre-tax basis. Traditional IRA contributions may be deductible, which functions like an income deferral, but their deductibility begins to phase out at higher income levels. In 2018, phaseouts begin at $63,000 for single filers, and $118,000 for married couples filing jointly. Roth IRA contributions are not eligible for deduction. But unlike withdrawals from company sponsored retirement accounts or Traditional IRAs, withdrawals from Roths are not taxable.
In 2018, 401(k), 403(b), and SEP accounts offer the greatest deferral amount limits of all generally available account types: 100% of income up to $18,500 for people under age 50, and $24,500 for those 50 and above. SIMPLE IRAs are lower ($12,500 under 50, otherwise $15,500), and lower still are Traditional IRAs and Roth IRAs: $5,500 under 50, and $6,500 for 50 and over.
Certain company-sponsored retirement accounts also include employer matching or profit-sharing components. Matching arrangements vary by percentages and dollar limits, but the incentive is powerful, essentially offering free money for employees who choose to participate. If you’re fortunate enough to have a profit-sharing component to your 401(k), your saving opportunity is tremendous: profit sharing contributions + employee deferrals have a combined dollar limit of $55,000 in 2018.
With certain exceptions for hardships or temporary borrowing, the money in all retirement accounts needs to stay there until you’re at least 59 ½ years old. Withdrawals prior to age 59 ½ will likely be subject to a 10% IRS penalty and possibly income taxes. At age 70 ½, the IRS mandates that you begin to take money out of these accounts – they want to collect taxes that you’ve deferred in prior years. These mandatory withdrawals are called Required Minimum Distributions, or “RMDs” for short. Roth IRAs and Roth 401(k)s are unique in that they are not subject to the RMD requirement.
Prioritizing Retirement Account Options
With the above as background, let’s first consider two broad principles:
Principle #1: Maximize profit sharing and matches. If your employer is going to give you free money for retirement, it’s too good to pass up. We nearly always recommend contributing to a 401(k) at least to the point where your employer’s match is maxed.
Principle #2: Deferring taxable income is almost always the right choice. Mainly this is because the amount you would’ve paid in income tax also grows tax-deferred. If you have high income, your company retirement account offers the surest way to lower your income tax bill. Taxpayers without a company retirement plan, or those with income below the phaseout ($73,000 for single, $121,000 married) can deduct at least part of the contribution to a Traditional IRA. Roth 401(k)s and Roth IRAs become attractive if you’re confident that your current tax bracket is lower than it will be in retirement.
Here’s how we generally recommend clients prioritize their account saving options:
- Company Retirement Accounts with profit sharing or matching, and SEP IRAs
- Company Retirement Accounts with only employee deferrals
- Traditional IRAs, if the contributions are deductible
- Traditional IRAs if contributions are not deductible, Roth IRA contributions and conversions
Don’t stop saving! While prioritizing retirement accounts can be helpful, its impact is small compared to the discipline of saving. There are no retirement accounts or investment strategies that can compete with the power of spending less than you earn and saving the difference.