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Your retirement account options

by retirebyforty on November 5, 2012 · 20 comments

in investing, retireby40's investing fundamentals, saving

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different retirement account options

This is part 4 of my Retirement advice for young folks series. Last time, we talked about starting to invest as early as possible and this time we’ll go over some of the retirement accounts available. There are a few different retirement account options which could be confusing to young folks who just started their first job. I was extremely lucky that my dad pushed me to invest in the 401(k) right away. After a few years I maxed out the contribution and looked for other ways to increase retirement contribution. That’s when I found out about the Roth IRA. In fact, it’s better for most people to contribute to the Roth IRA before maxing out the 401(k). I didn’t know this when I first started.

I’ll go over what I know now and some simple strategies to maximize the tax benefits these different accounts offer. This is by no mean comprehensive and it might not be the right move for everyone. Your retirement plan isn’t the same as mine and you’ll need to make your own decision. You can skip to the end to see my strategy if you are familiar with various retirement accounts.

Tax deferred retirement account

These accounts include a company’s 401(k), Thrift Saving Plan (Federal employees), and 403(b) (public education organization). An employee can make contributions to this retirement account on a pre-tax basis. This means you will put off paying tax on this investment until you make a withdrawal in retirement.

For example, if you make $50,000 per year and contribute $5,000 to the 401(k), then you’ll only pay tax on $45,000 of your income. This is a great advantage to you because you’ll have more money to invest. If you skip the 401(k) and invest in an after tax account instead, you’ll only have $3,750 in your account instead of $5,000. This is assuming you’re single and you’re paying 25% marginal tax rate on that $5,000.

Additionally, many employers will match a portion of your contribution. What does this mean exactly? Let’s say your employer matches 5% of your salary. In the previous example, they’ll add $1 for every $1 you contribute up to $2,500. With the matching, your 401(k) balance is already up to $7,500 even before you start investing. That’s twice the amount you would have if you had gone with an after tax account instead.

2012 401k maximum contribution limit: $17,000

2013 401k maximum contribution limit: $17,500

IRA – individual retirement account

The IRA is not tied to an employer like the 401(k) and TSP. You can open an IRA account with any stock broker. There are two main types of IRA – Traditional and Roth. Each year you can contribute to one or both of these accounts up to the contribution limits.

2012 IRA contribution limit: $5,000

2013 IRA contribution limit: $5,500

Traditional IRA

Contributions to a traditional IRA are tax deductible in the year a contribution was made. The growth of the account is tax deferred until you make a withdrawal in retirement. This is similar to the 401(k) we discussed previously. The difference is you’ll have to invest with a brokerage firm instead of your employer’s 401(k) trustee.

Roth IRA

The contribution to the Roth IRA account is NOT tax deductible. Then what’s the use, you ask. The main advantage of the Roth IRA is you won’t have to pay tax on the gain. If you wait until retirement age and avoid an early withdrawal penalty, then you won’t have to pay any tax when you withdraw from this account.

IRA limit

Your contribution and deduction may be limited if you or your spouse participate in a retirement plan at work AND your income exceeds a certain level. See the contribution and deduction limit at the IRS.

Roth 401(k)

Your employer may offer a Roth 401(k) plan. This plan is new (since 2006) and not all 401(k) plans have this option. This plan is similar to the Roth IRA plan. The contribution is after tax, but you won’t have to pay tax on the earnings in this account.

Investment strategy

Most young people don’t make a lot of money because they are just starting out. You may not be able contribute up to the limit on these retirement accounts. Here is one strategy to follow. Once you surpass step 1, then go to step 2, etc…

  1. Contribute to the traditional 401(k) account to get the entire employer matching.
  2. Contribute to the Roth IRA up to the max.
  3. Contribute to the traditional 401(k) account up to the max.
  4. Consider changing new contribution to Roth 401(k).

Steps 1 to 3 are pretty standard and it can take quite a few years to get there. For 2012, that’s $17,000 in the 401(k) and $5,000 in the Roth IRA. What about step 4? Why change to Roth 401(k) and lose the tax deduction?

Invest more

You are simply investing more when you put $17,000 in the Roth 401(k) rather than the traditional 401(k). You already paid tax on this $17,000 and won’t have to pay anymore tax in the future.

Earning growth

Over 30 years, your investment earnings can easily bypass your original investment. A $17,000 investment in the Roth 401(k) can grow to over $180,000 in 30 years at 8%. You won’t have to pay a dime of tax when you withdraw this $180,000 if it’s in the Roth 401(k). On the other hand, if this $180,000 is in the traditional 401(k), you’ll have to pay the regular income tax rate when you withdraw.

Tax strategy

The Roth accounts can also help with your tax strategy when it’s time to withdrawal. You can avoid the higher marginal tax rate by mixing the withdrawal from both the traditional and Roth accounts. See example below.

Withdrawal example

Let’s say you need $50,000 per year to live a comfortable retirement.

You can withdraw $35,000 from the traditional account and $15,000 from the Roth accounts. This strategy will let you avoid the 25% marginal tax rate.

Closing

It can be a bit confusing, but the most important thing is to start investing as early as you can. The earlier you can max out your retirement account contributions, the more comfortable you’ll be in retirement. If you wait until you’re 40, it will be much more difficult to build up an adequate retirement fund.

Other type of IRA and 401(k)

I don’t have enough experience with SEP IRA, SIMPLE IRA, and Self Directed IRA to talk about them much. You can find more info on Wikipedia if you are interested in these IRAs. I also don’t know much about solo 401(k). Once I’m more successful at self employment, I’ll probably look into these options more.

 

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{ 19 comments… read them below or add one }

Lance@MoneyLife&More November 5, 2012 at 6:18 am

I personnaly Max out my Roth IRA and contribute to my Roth 401(k) at work as well. I am not close to maxing out the 401(k) yet and don’t know if I will soon but it is definitely a goal. Keep in mind if you want to retire early though you probably need money in a taxable investment account as well.

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savvyfinanciallatina November 5, 2012 at 7:07 am

I have a 401k that invest in and I just contributed to a ROTH IRA for me. Hubby doesn’t have a 401K so we will have to rely on the ROTH for him.

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savvyfinanciallatina November 5, 2012 at 7:09 am

Of course, I decided to invest in my ROTH right before the elections. Bah…money is fluctuating so much right now. Truly show how little I know about timing the market :p

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Thomas S. Moore November 5, 2012 at 11:09 am

I like the max out 401k then contribute to the Roth. However I don’t think my taxes will be the same with a Roth 401k down the road. If I am taxed at 25% now I would only think I would be taxed less when I dont need as much down the road.

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retirebyforty November 7, 2012 at 2:00 pm

It’s hard to forecast 30 years into the future. I think the best plan is to make sure we have investment in both Roth and traditional account.

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Ed November 11, 2012 at 7:00 am

I agree, use both accounts.

Seeing the financial problems the US of A is in and continuing to be in, it is my opinion that taxes can only go up and new ways of taxation may appear. i.e. national sales tax or value added tax

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retirebyforty November 11, 2012 at 3:26 pm

A VAT tax is going to be tough to pass. We probably won’t see tax this low ever again…

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SMB November 5, 2012 at 2:24 pm

Right now I’m contributing up to my employer’s match (5%) into my TSP. Then I’m maxing out my Roth IRA. I’ve really wanted to start adding to this and I looked into the Roth TSP option, but I was confused about the limit. Does contributing to a Roth IRA affect your Roth TSP (or 401k) limit? Or is my TSP limit the limit for the regular TSP and Roth TSP combined (not that I’ll get close to that)? There was a surprising lack of information about this on the TSP website and I couldn’t find anything on the IRS website either, but perhaps I wasn’t looking in the right places.

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retirebyforty November 5, 2012 at 2:55 pm

Oh wow, I didn’t know there is a Roth TSP. That’s great news.
The Roth IRA does not effect your Roth TSP limit. You can max out Roth IRA at $5,000 and then max out the Roth TSP at $17,000. That’s what I did in 2010 with my 401(k).

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T3 November 5, 2012 at 3:08 pm

SMB, I’ve done a ton of research on this lately and finally discovered that the limits do not affect one another between employer sponsored plans (401k, 403b, TSP, etc.) and Individual Retirement Accounts (both Roth and Traditional). So you can contribute 17,000 in 2012 to your TSP and 5,000 to an IRA, pending all those pesky income limits.
TSP says that if you contribute to their Roth TSP over the Traditional TSP you may make yourself unable to contribute to a Roth IRA if you are near the income limits as the pre-tax deduction can significantly lower your IRA computed “modified AGI” (and yes, there’s a different AGI just to figure out how much you can contribute to your IRA, the modified AGI it doesn’t count rental income and there are a few other changes).
RB40, love this site, wish I had discovered your methods 10 years ago so I could be on the same track.

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SMB November 6, 2012 at 10:44 am

Thanks for your replies! I guess I’ll try to start adding to a Roth TSP too.

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krantcents November 5, 2012 at 5:56 pm

The most important part about investing is time. The earlier you start the better off you will be. It will counter asset allocation or investing mistakes.

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retirebyforty November 7, 2012 at 2:02 pm

That’s why I tell everyone to invest as much as you can when you’re young.

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FI Fighter November 5, 2012 at 7:40 pm

Yep, I agree that time is the most important component for success.

As shown in the Bogglehead’s Guide to Investing, if you start at 25 and invest $4000/year into a Roth, you can stop after 10 years with a total investment of $40,000. At 8% return, you will have $629,741 by age 65.

If you start at 35, and invest $4000/year for 30 years you’ll have contributed a total investment of $120,000. With the same 8% return, you’ll have $489,383.

By starting 10 years earlier, you can contribute 1/3 less and still come out ahead!

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retirebyforty November 7, 2012 at 2:03 pm

Why stop after 10 years. I guess if you retire by 40 like me, you won’t be able to contribute as much. :)

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justin@thefrugalpath November 6, 2012 at 7:11 pm

My wife’s 401k contribution goes into a Roth 401k, but the company match goes into a regular 401k account. This is our first year with it, so I’m not sure what type of impact this will have on our taxes next year. However, her paycheck hasn’t taken too much of a hit and we shouldn’t have to worry about paying taxes on any of the money in the Roth 401k.
If we were in a higher tax bracket we may have considered a regular 401k, but atm we’re in the lower bracket, so it’s a no brainer for us.

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retirebyforty November 7, 2012 at 2:05 pm

Yes, that’s the rule. Employer matching can’t go into the Roth. Great decision while you are in the lower tax bracket. Mrs. RB40 is changing to Roth 401k next year too because our tax bracket should be lower.

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Jason November 18, 2012 at 7:42 am

Solo 401K is easy to work and set up. You can reduce Schedule C or K-1 income this way. I have mine at E-Trade. The big rule is that it has to be funded before year end.

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retirebyforty November 18, 2012 at 11:28 pm

Once I make money I’ll definitely open up a solo 401k. It might take a couple of years though.

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