Given all the options available today for self-directed retirement savings plans, either employer-sponsored or government-sponsored, you may be wondering what plan makes the most sense to plow your hard earned money into. The short answer is it depends.
There are a few factors you need to take into account when deciding which retirement savings plan to go with. Start with the 401(K). Does your employer offer a match? Does the plan offer a good selection of low-fee funds? Take into account the maintenance and other fees of the account itself. If you can check off the boxes on these, it can be a good choice. If on the other hand, it doesn’t meet these requirements, both a Traditional IRA and Roth IRA can be good alternatives. You have better control over your investment choices and you can either get the tax break up-front (Traditional IRA) or when withdrawing the funds during retirement (Roth IRA).
While everyone’s situation is different based on age, investment horizon, and available income, setting money aside in one of these types of plans will help you be better prepared for retirement when the time finally comes.
Does Your Employer offer a 401(K) Match?
Employees are more and more likely to have employer-sponsored retirement savings plans, such as 401(K) or 403(B) plans, that make employees responsible for funding their own nest eggs and deciding how to invest the money.
These plans can be a great way to shelter your earnings upfront from taxes. In addition, your employer may offer a match for every dollar you put in, up to a limit. Contribution limits are established yearly by the IRS. You can view details on the IRS website.
If your employer offers a match, you should take advantage – at least up to the maximum of the match. This is essentially added income that you would be leaving on the table if you don’t take advantage of it.
What if My Employer Doesn’t Offer a Match?
If your employer does not offer a match, you can still take advantage of the tax break up front. Another benefit is that the money gets automatically deposited from each paycheck. This forces you to save without having to think about it much.
However, whether or not this is your best option depends on the quality of the investments in your company’s 401(K) plan. What you want to look for are funds that have very low expenses. Fees and expenses can really eat up your retirement savings, so you want to avoid funds with high fees.
Generally, managed mutual funds carry higher fees than passively managed funds. Given that only a small fraction of actively managed funds outperform passively managed funds or index funds, and the ones that do vary from year to year, it makes sense to opt for lower fee passive funds.
The Traditional IRA Alternative
If you find that either because of the fund choices available in your employer’s plan or lack of a company match you’d rather invest elsewhere, there are other options to shelter your earnings from taxes upfront. One of the more popular options is the Traditional IRA.
With the Traditional IRA, you get a tax break from money invested up to the maximum limit set by the government. The total amount you will be able to invest is considerably less than through a 401K plan. However, the advantage is you have better control over your investments.
You can open up a Traditional IRA with any brokerage house. This will allow you to select your investments from a wide variety of investments. You’ll have the option of selecting from mutual funds, both actively and passively managed, index funds, individual stocks, options and other investment vehicles.
Greater Choices Come with Advantages and Risks
This, of course, is a double-edged sword. On the one hand, the flexibility is a major advantage. On the other hand, the variety of choices may seem overwhelming. It also opens up the possibility for selecting investment types that carry a greater degree of risk. These include individual stocks, options, futures, among others.
The wisest approach is to stick to passively managed funds or index funds with low fees that offer adequate diversification. You don’t have to pick many. A Total US Stock Market index fund, a Total International index fund, and Total Bond Market index fund should be enough to give you proper diversification.
If you want to diversify a bit further, you can add a Total Emerging Market index fund and possibly one or two specialized funds. But these are not a must. You would do perfectly fine with the three types of Total Market funds previously mentioned.
Individual stocks can make up a small portion of your retirement portfolio if you enjoy stock picking. But diversify your selections and keep the total percentage small relative to the overall portfolio. No more than 10 percent at most.
Consult with your financial advisor if you are going to include individual stocks or other investment instruments. This is a retirement account, you do not want to be putting your money at too much risk.
The Roth IRA Alternative
The Roth IRA can also be a great alternative. While you will not get a tax break up front, you will have the opportunity to allow the money to grow over time. And the best part is, when withdrawing it you will not owe any taxes on the income.
This can be particularly advantageous if you have a long time frame to work with. Compounding can work in your favor with a long time horizon. You stand to generate a substantial amount in earnings on the principle.
What is often recommended is that if you believe your income will be higher at retirement than it is today, then the Roth IRA makes more sense. If the opposite is true, then the Traditional IRA may be the better choice. However, with a long time-frame, the tax-free compounded income advantage makes the Roth IRA the better choice.
Of course, since you are paying taxes on the dollars invested upfront, this is something you will want to weigh as well. After all, the Traditional IRA allows you to get a nice tax break at the end of the year. This is something you will surely appreciate come tax season.
What if I Don’t Qualify for a Roth IRA?
One of the catches of both the Traditional and Roth IRA plans is that they come with an upper limit on personal income. If your income exceeds the amount set forth by the government, you can’t fully take advantage of the two IRA retirement savings plans.
You have a couple of options in this case. If you determine that for your situation paying taxes up front makes sense in order to not have to pay them when withdrawing the funds during retirement, you can check with your company plan to see if they offer a Roth 401(K).
The Roth 401(K) also offers the advantage of not having to pay taxes when withdrawing the funds. Best of all, there is no income limit to qualify. All of this, of course, assumes you do not withdraw your money earlier than allowed by federal guidelines.
A second option, known as the back door method, involves contributing post-tax money into a Traditional IRA. You will not benefit from taxes in the Traditional IRA account. However, you can then convert the money invested to a Roth IRA and benefit from tax-exempt compounding when withdrawing at retirement.
If you receive any earnings from your investments in the Traditional IRA, you will need to pay taxes on those earnings. You can avoid this by making the conversion as soon as possible after depositing the funds.
Contribute Regularly and Start Early
While we can’t turn back the clock, the best time to start investing towards your retirement is now. Contribute regularly to take advantage of cost averaging. This will take the pressure of having to time your investments off your shoulders.
If possible set up automatic investments into the account. This is usually automatic in company-sponsored 401(K) retirement savings plans. But you also have the option of having the funds deposited regularly and automatically into either a Traditional or Roth IRA.
Most brokerage accounts offer this option today. If you are unsure, contact them and ask how you can have funds automatically deposited either from your bank account or if your employer allows it, directly from your paycheck.
While having money taken either from your paycheck or banking account can be tough when you are living on a tight budget, you will be investing in your future. Contribute as much as you can and start as early as possible.
One of the advantages of having the money come out before you see it is that it forces you to budget your spending better. You can find ways to cut back on the things you really don’t need. Keep a log of where your money is going each month. You’ll be surprised to find much of it goes to trivial things.
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