Saving for retirement is crucial. Yet trying to figure out the best retirement plan may leave many people confused.
You may have the option to contribute to an employer-sponsored plan, like a 401(k) plan. There are also individual retirement accounts: the traditional, into which contributions are made pre-tax, and Roth IRAs, in which you contribute money after tax.
There are a number of factors to consider in making your decision, depending on your age, employment and income.
You may have the ability to contribute to a retirement plan sponsored by your employer, typically a 401(k). Contributions are automatically deducted through your paycheck pre-tax, which lowers your table income. Once you withdraw the money in retirement, it will be taxed as income. The rate will therefore depend on your tax bracket at the time.
The big advantage of the 401(k) is that you can save up to $19,500 for 2020, regardless of income, said personal finance expert Chris Hogan, author of “Retire Inspired” and “Everyday Millionaires.” He is also part of the Ramsey Solutions group and hosts an online show, “The Chris Hogan Show.
With IRAs, you can only contribute $6,000 this year. If you are age 50 or over, you can save an additional $6,500 in your 401(k) this year or an additional $1,000 in your IRA.
With a 401(k), your employer may also match up to a certain percent of your contributions. More than three-quarters, 76%, received an employer contribution in the second quarter of 2020, according to Fidelity. The average employer contribution was $1,080.
If you have an employer match, you should at least put enough into the 401(k) to take full advantage of the match, Hogan said.
“It’s free money,” he said.
When you hit 72, you’ll be required to take a required minimum distribution, or RMD, from your 401(k) whether you want to or not. Those facing an RMD in 2020 are allowed to skip those withdrawals thanks to the CARES Act.
Contributions to Roth IRAs are made after tax, so you don’t have to pay taxes when you take money out in retirement.
However, there are income limits. You can contribute the maximum of $6,000 (or $7,000 if you are 50 and over) if you make less than $196,000, if you are married and filing jointly, or less than $124,000 if you are single. You can contribute a reduced amount if you make between $196,000 and $206,000 and are married or between $124,000 and $139,000 if you are single.
If you are younger, a Roth may be the way to go, said David Clausen, a Los Angeles-based certified financial planner and wealth management advisor for Northwestern Mutual.
“It is great to build up those Roth funds when you are younger because you may not qualify when you are older,” he said.
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Pete Hunt, a CFP and director of client services at Exencial Wealth Advisors, is a huge fan of Roths because he thinks tax rates will only go higher in the future. Therefore, it’s better to pay taxes now at the lower rate, he said.
“I recommend it to all my clients, unless they are in a situation where they think they will make significantly less income in the future,” said Hunt, who is based on Charlotte, North Carolina.
There are also no required minimum distribution with Roths and you can withdraw your contributions at any time, tax- and penalty-free. You generally can’t tap into any earnings until you reach 59½. You also typically have more investment options than you do in a 401(k).
It also doesn’t have to be an either-or situation. If you have a 401(k) but also qualify for a Roth IRA, do both, Hunt said.
First, contribute up to the employer’s match for the 401(k). He then recommends putting money in a health savings account, if you have a high-deductible health-care plan. After that, put money into a Roth, he said.
“I like having a Roth IRA, if they are eligible for it, just because it gives a lot of flexibility that if they need that money, they can pull the contributions at any time for any reason,” Hunt said.
For those who don’t qualify for a Roth IRA, contribute as much as you can to your 401(k) or traditional IRA.
A Roth 401(k) combines what is best about a 401(k) and a Roth IRA.
Contributions are made after tax, so you won’t pay taxes when you take the money out in retirement, like the Roth IRA. However, like the traditional 401(k), there are no income limits and you can contribute up to $19,500 this year, plus the additional $6,500 for those 50 and over.
When it comes to choosing between a Roth 401(k) and a traditional 401(k), Hogan said it’s a Roth 401(k) all day long.
“That’s putting almost $20,000 away tax-free each year,” Hogan said.
Hunt also generally recommends the Roth 401(k).
“A Roth 401(k) essentially allows you to put more money away than a traditional 401(k), even though the amounts are technically the same,” he said.
“$19,500 (or $25,000 if over age 50) of after-tax money is far more valuable than the same dollar amount in pre-tax money, especially over many years.”
There is just one caveat, Hogan pointed out. If your employer is offering a match, it is treated like the pre-tax 401(k), which you will pay taxes on when you take it out during retirement, he said.
Roth 401(k)s are also subject to RMD rules, which means you’ll have to start taking money out by age 72.
A traditional IRA is good for those who don’t qualify for a Roth IRA or don’t have a 401(k). An IRA can also be used to roll over any 401(k)s from previous employers.
Generally, you should never leave your 401(k) from a previous job with that employer, Hunt said.
If you are happy with the investment options in the plan, then you can roll it into your new 401(k) to keep things simple, he said. However, if you had a plan with high expense ratios, then roll it into an IRA.
With IRAs, you have a $6,000 contribution limit for 2020, or $7,000 if you are age 50 and older.
A Roth 401(k) essentially allows you to put more money away than a traditional 401(k), even though the amounts are technically the same.
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An IRA may also work for someone who has an income-based student loan payment. By putting money away in retirement pre-tax, you’ll reduce your adjusted gross income. That will lower your student loan payment.
Then there is something known as a back-door conversion. If you don’t meet the income limits for a Roth IRA, you can contribute after tax to a traditional IRA and then convert it to a Roth.
It’s best to sit down with an investment or tax professional to walk you through all the nuances of how to do it, said Hogan.
“If you have the money to pay the taxes on that money, it is a fantastic thing to do each and every year,” he said.
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