Saving for Retirement: IRA vs. 401(k)
Retirement was simpler when all you had to do was put in your time at work, retire and collect your check. Between the company pension and Social Security, most retirees figured they had it made. And if they'd managed to save a little extra, it was gravy.
These days, that's all changed. Traditional defined-benefit pension plans have become a thing of the past for most workers. And few people seriously expect Social Security to provide the majority of what they hope to spend in retirement.
In short, our ability to save and invest on our own will likely determine whether we realize the retirement of our dreams-or just hope to get by somehow when we're no longer able to work for a living.
Recognizing the need to save for retirement is the first step. That's followed by prudent retirement planning, which includes figuring out when you'd like to retire, how much you'd like to spend in retirement, and how much you need to save and invest now to get there.
After all that, you might think your next step would simply be to start saving, but with all the different retirement accounts out there-401(k), 403(b) or 457 plans at work, traditional IRAs, Roth IRAs, regular brokerage accounts, deferred annuities-it can be hard to know which are best for you, and in what combination.
Retirement workhorses: IRAs and 401(k)s
Your main workhorses for retirement savings will likely be an IRA along with a 401(k), 403(b), 457 or other qualified employer plan, depending on what your workplace offers.
If you have earned income but your employer doesn't offer a retirement plan, you can always start by putting money in a traditional IRA or Roth IRA, but if you also have access to a 401(k) or other employer plan, should you fund your 401(k), your IRA or both?
The best choice is to fund your tax-advantage options to the fullest if you're eligible, then move on to other ways to save for retirement if you're able, but what if you can't afford to save that much?
Got a match?
If your 401(k) offers a matching contribution, that's usually the best place to start. For example, let's say you make $50,000. Your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary, which for you amounts to $3,000. In this case, the first $3,000 of savings should go into your 401(k) plan. Why give up free money?
If you're able to save more than your employer will match, should you put the rest into your 401(k)? Or should you consider a traditional IRA or Roth IRA?
IRA vs. Roth IRA
Money you put in a traditional IRA is generally tax deductible no matter how high your adjusted gross income (AGI) might be-unless you're an active participant in a qualified employer plan such as a 401(k), 403(b) or 457.
Contributions to a Roth IRA are never tax deductible, but qualified withdrawals are tax-free (unlike withdrawals from traditional IRAs, which are taxed as ordinary income). For 2007, you can contribute the maximum $4,000 to a Roth IRA if your AGI is below $95,000 for single filers and $150,000 for married filing jointly. You can make a partial contribution if your AGI is between $95,000-$110,000 for singles and $150,000-$160,000 for married filing jointly.
If you're still able to save more after taking advantage of your employer's 401(k) match limit, here's what you should do next:
The bottom line
- If you're eligible to make a deductible contribution to a traditional IRA, consider putting your next $4,000 there-especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals. You're still getting a pre-tax deduction as you do with your 401(k), but you'll likely have more investment choices. If you can afford to save more after contributing $4,000 to a traditional IRA ($5,000 if you're 50 or older in 2006), then continue with your 401(k) up to the maximum allowed.
If you're not eligible to make a deductible contribution to a traditional IRA but you're eligible for a Roth IRA, consider putting your next $4,000 into a Roth ($5,000 if you're 50 or older in 2007). Your contribution won't be deductible, but qualified withdrawals will be tax free down the road. If you're in a higher tax bracket when you make your withdrawals, the Roth would be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes-but a Roth IRA has other advantages.
A Roth IRA doesn't force you to take required minimum distributions at age 70½, as you'd have to do with a qualified employer plan or traditional IRA. That's an advantage in terms of letting your Roth IRA continue to grow tax deferred in your later years. It could also benefit your heirs, who'd be able take money out income tax free after you're gone.
Again, if you're able to save more after you put $4,000 in a Roth, continue with your 401(k) until you max it out.
- If you're eligible for neither a deductible contribution to a traditional IRA nor a Roth IRA contribution, then just continue with your 401(k) until you've contributed the maximum allowed.
If you haven't begun to save for retirement-or you're saving less than you should-what are you waiting for? Now that you know which retirement accounts make the most sense, start filling them up!