One of the most common questions asked concerning investing for retirement is which account to put your hard earned money into. The answer, as is often the case with finance, is “it depends”. There are a variety of retirement accounts out there and it can be overwhelming to figure out where to start.
As a primer for those just beginning in retirement planning/investing, or a review for those who understand the basics of retirement accounts, it is important to know these two things:
First, the long term wealth created by these tax advantaged accounts is your best bet for retirement savings.
Second, the price you pay for that advantage is that you must keep the money in those accounts until a pre-determined age or you will generally pay a 10% penalty on top of income tax on the money withdrawn.
There are exceptions to these rules, as always, but that is for a more advanced lesson, and I don’t care for them because it causes people to look at their retirement money as a potential emergency fund. I would like you to think of your retirement money as untouchable until retirement…just like I do.
The Most Important Retirement Accounts
As previously mentioned, there are many types of retirement accounts to put your money into. The following are a list of the most important accounts, in order of priority, and the reasons why you should utilize them in this order.
1. Employer plan that matches your contributions.
This is truly the best type of account because you literally get free money from your employer. Although contribution limits vary, they are generally $16,500 annually for 2011. (All numbers from here on in will be for 2011.) If you are over 50, you can contribute another $5,500 annually for a total of $22,000. However, your employer generally won’t match you dollar for dollar, and they won’t match all of your contributions.
For example, your employer may match you 50 cents on every dollar you invest up to 5% of your pay with a cap of $4,000.
Therefore, using this example, if you make $40,000, 5% of your pay is $2,000 which is below the maximum cap. Your employer will match you (give you) 50 cents for every dollar you invest up to your cap.
Since your cap is $2,000, if you invest just that amount, your employer will “give” you another $1,000 in that tax deferred account, totaling $3,000 plus any interest earned from the investment.
Every dollar you invest beyond the $2,000 will not be matched, however, it will be written off your taxes and it is still tax deferred.
It is hard to beat the earnings associated with a matched plan and this is why it is your number one choice for retirement accounts up to the point where your employer stops matching. You see, employer plans usually have limited investment options, therefore, after the employer match is met, it is best to look outside of your employer and put your money into a Roth IRA.
2. A Roth IRA
The first thing to consider when looking at a Roth IRA is simply “do you qualify.”
Your contributions to a Roth IRA begin to phase out when your income reaches $105,000 ($120,000 for joint filers). You will become completely ineligible to contribute when your income reaches $120,000 ($177,000 for joint filers).
If your income is above these numbers, move onto the traditional IRA. If not, enjoy reading about the best tax deferred account in history.
What is great about the Roth IRA is that you not only get the tax-free growth of other plans, but the Roth is unique in that you never pay taxes when you withdrawal.
You lose your annual tax deductions that you would get from your employer plan or a traditional IRA, but that doesn’t compare to the lifetime of tax free withdrawals. The other great thing about the Roth (as well as a Traditional IRA) is that you have a much greater range of investments to choose from.
It’s advantages…
Your employer plan may only have 5 options to choose from, for example, but an IRA will allow you to invest in all of the stock market (as well as other investments).
The other good thing about a Roth is that you do not have to withdraw your funds at a particular age as with other accounts. You could let it sit and grow until the day, well, the day you give it to your heirs or to charity. The contribution limit for a Roth IRA is $5,000.
At this point we will recap and determine the next step…
We have determined that your best bet is an employer matched retirement account, such as a 401k, 403b, TSP, etc. (Those are just a few of the different names for these accounts, depending on whether you work for a private company, the government, etc.)
Once you have maxed out your employer match, the Roth IRA is generally the next best option. It increases your investment options and reduces your taxes upon withdrawal. Your next step will be to determine how much money you still have available to invest and how good your employer investment options are.
Using the example above, you maxed out your employer contributions at $2,000 and maxed out your Roth IRA with $5,000 for a total of $7,000. But lucky you…you have more to invest!!!
If you are happy with the options available in your employer plan, continue to contribute until you max out that plan (which again is $16,500 if you are under 50).
This would allow you a maximum investment amount of $21,500 between the two accounts. If you are not happy with your investment options in your employer plan, you may consider a taxable account, but I do not recommend that until you have maxed out all retirement accounts. Even without a company match beyond the cap, it is hard to beat the money saved from the pre-tax write-off.
3. Traditional IRA
What If you are unable to qualify for the Roth IRA? You can qualify for a Traditional IRA, which is similar to both the Roth and your employer plan.
The contribution limits are the same as the Roth IRA and you have the similar investment options, but the tax deductions work in the same way as your employer plan. You get the pre-tax write-off but pay taxes when you withdrawal.
The thought behind this is that when you retire you will be in a lower tax bracket, therefore getting the double benefit of lowering your current taxes and being taxed less when you withdrawal.
There is always a catch, and with the Traditional IRA there is an income limit in order to get the write-off. Those limits change almost every year, so check the IRS website for current limits. You can still invest in the account, and your money will still grow tax deferred, but you may not get the initial deduction.
4. Taxable Accounts (Brokerage Accounts) And Annuities
The two final investment vehicles (for employees) are taxable accounts (brokerage accounts) and annuities, which is an investment as opposed to an account.
Most Do-It-Yourself investors, investment sights, and advisers (that don’t peddle annuities) would recommend annuities be a last option and put your money into individual stocks or mutual funds through a brokerage account.
This is not bad advice, but to ignore annuities would be foolish. Annuities are complicated, have high fees, restrict your investment options and lack liquidity. However, they are a great source for a lifetime income stream to add to your retirement accounts, pension, or even your retirement job should you choose to have one.
What investments to choose for your taxable account or which annuities to choose for your retirement income stream is a different article. That is coming soon and is entitled “The Best Investments for Your Retirement Accounts.” Also, stay tuned for the best investments and accounts for entrepreneurs!