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
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.
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.
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.
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.
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…
- Contribute to the traditional 401(k) account to get the entire employer matching.
- Contribute to the Roth IRA up to the max.
- Contribute to the traditional 401(k) account up to the max.
- 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?
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.
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.
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.
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.
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.