In the fabled days of yore, you could likely get by in retirement by depending on a pension from your lifelong employer, and the help of Social Security. However, those days are long gone.
Most companies no longer provide employee pension plans. And for the millennial generation, Social Security may just be a pipe dream, as the Social Security Administration reports that trust fund reserves will be exhausted in 2037.
Unfortunately, it seems that many Americans do not have a viable retirement plan in place to meet these changes. In fact, a recent study found that one in three Americans have less than $5,000 saved for retirement.
But all is not lost. There are options available that can allow you to retire at a reasonable age in reasonable comfort.
While the traditional pension plans of your parents and grandparents may have disappeared, the U.S. government offers tax breaks on several types of retirement accounts to help the average Joe prepare for the future. However, navigating the alphabet soup of retirement plans — 401(k)s, 403(b)s, IRAs, Roth IRAs, SEPs, and more — can be daunting.
Here, we’ll explain what each of these accounts are, and help you decide which is best for your current and future financial stability.
Why Choose a Tax-Deferred Retirement Account?
But first, why should you use a specified retirement to save for your retirement in the first place? The answer is simple: tax savings.
Let’s assume you earn$100K a year, and you’re trying to decide between putting 10% of your income, or $10,000, into a tax-deferred retirement account or a taxable investment account. In this particular case, let’s say the funds will earn an 8% annual return in both accounts.
If you decide to put your $10K into a taxable account — and also assuming you actively manage and rebalance your account each year — you will likely face 24% tax on that return each year. In other words, your after-tax annual return on the fund is 6.1% in reality, rather than the full 8.0%.
On the other hand, if you were to invest the $10K into a tax-deferred account, in this case a Roth 401(k), the funds will earn the full 8% annual return. You will also not be required to pay a short-term capital gains tax if and when you reallocate your investments. While a difference of 1.9% net return may not seem significant, over time, it adds up.
As you can see in the chart above, after 50 years, the tax-deferred account will accumulate more than double what you would have in a taxable account.
The Best Retirement Strategy in 3 Steps
So now that we know tax-deferred retirement accounts are an amazing means of boosting the return on your investment, how should you begin?
Step 1: Match Employer Contributions on Your Employer-Sponsored Retirement Account
For the majority of readers, the answer is with an employer-sponsored retirement account, also called a defined benefit plan.
Most companies now offer a defined contribution plan, but the type available to you will depend on the type of company you work for. If you work in the private sector, you will likely have a traditional or Roth 401(k) option, while if you work in the public or nonprofit sector, your plan will be called a 403(b) or 457(b).
No matter what type of plan is available to you, you should begin your retirement planning by putting enough into the account to earn any employer match. This is usually a percentage of your contribution that often ranges from 2% to 6%.
For example, let’s say your employer will match 50% of any contribution you make up to 6% of your gross annual salary. If you make $50,000 per year, that means you should contribute 6% of your salary, or $3,000 each year to get a matching contribution of $1,500 from your employer.
The primary advantage of these accounts is, again, their ability to grow your money in a tax-deferred account. This allows your money to gain interest on its own interest without the need to pay Uncle Sam for the gains you make annually. As we saw in the previous section, that can add up to quite a chunk of change in the long run.
While the payoff in the future is great, all these accounts — with the exception of the Roth 401(k) — can also reduce the amount you pay in taxes now. When you contribute from your salary before tax, you’re actually lowering your adjusted gross income, which means you pay less now and could even potentially knock yourself into a tax bracket.
Step 2: Max Out Your Individual Retirement Account (IRA)
All the employer plans mentioned above suffer from similar drawbacks: potentially high fees and the inability to choose your plan for yourself. For this reason, after you’ve contributed enough to your employer-sponsored plan to capitalize on any matching contributions, we recommend you divert your hard-earned cash into an individual retirement account (IRA).
IRAs tend to have much lower fees, as well as a more diverse set of investment options. This is because IRAs often allow funds with low-cost ETFs versus the higher cost mutual funds chosen by many employer retirement accounts. After all, the average fees for a 401(k) — including management fees and expense ratios — is 1.00%, but can be as high as 2.00%. On the other hand, many IRAs have no management fees at all.
While a 1.00% to 2.00% fee may not sound like a lot, it can be very costly. As an example, let’s say a 25 year old chooses to invest solely in her 401(k) throughout her career without diversifying into an IRA.
The 401(k)s offered by her employers have total fees averaging 1.5%. She starts today with a $20,000 investment, and contributes an additional $10,000 every year after that until she retires at the age of 65. Assuming an 8% return each year, she would have about $2.1 million in retirement. But she will have paid $405K in fees over that time.
In comparison, if she had put that amount in a combination of low fee 401(k) and IRA accounts with total fees of 0.50% on average, she would have saved $238K in fees and instead would have a total of $2.8 million when she retires, which is an additional $700K.
What Type of IRA Is Right for You?
As you can see, diversifying your retirement savings between your employer-sponsored account and a personal IRA is a smart way to maximize your returns. But which type of IRA should you choose?
The three most common types of IRA for the average person are the traditional IRA, the Roth IRA, and the SEP IRA. Each has its own advantages and disadvantages. The one you choose will likely depend on your current employment status and income level, as well as the level of income you anticipate in retirement.
- Traditional IRA: The traditional IRA allows you to contribute your earned income before tax. This means it could potentially lower your current tax burden if you’re a high earner. However, the drawback to not paying taxes on your contributions now is that you will have to pay taxes when you withdraw from the account in retirement. Many people choose this option because they anticipate they will have a much lower income level in retirement (sometimes none), and will therefore pay a lower tax rate on the withdrawals. One catch is that if you make more than the annual income limit, you may not be able to deduct contributions.
- Roth IRA: This type of IRA allows you to contribute your earned income after tax. In contrast to the traditional IRA, the Roth will not decrease your tax burden for the year you contribute. The advantage is that you can withdraw this money tax-free in retirement since you’ve already paid Uncle Sam his due. One catch is that if you make more than the annual income limit, you may not be eligible to invest directly into a Roth IRA. If desired, you can do a backdoor Roth conversion to get around this, it’s just a bit more complicated.
- SEP IRA: The Simplified Employee Pension, or SEP IRA, is designed for those who are self-employed, sole-proprietors, or small business owners who may not be able to shoulder the costs of starting and operating a conventional plan, but still want to provide a way for employees to save for retirement. Similar to a traditional IRA, earnings in a SEP IRA grow tax free, but are taxed upon withdrawal.
Once you’ve chosen the right IRA for you, you can put your money to work. Ideally, we’d recommend you max out your IRA contributions, as this will help ensure you’ll enjoy a healthy retirement income in the future. Also, maxing out your IRA is required if you’re going to move on to the last and final step of your three-step retirement strategy.
Step 3: Max Out Your Employer-Sponsored Retirement Account
While contributing $19,000 this year to your employer-sponsored account may not be possible in your particular situation, if you’re able, you should try to contribute as much as you can. After all, you already did the hard work of figuring out the best retirement plan for you. Setting up a recurring contribution is the easy part.
In the End, Investing for Retirement Boils Down to 3 Steps
Retirement planning may seem like something you need a specialized financial advisor to do for you, but it’s really quite simple and can be broken down into three simple steps:
- Contribute enough to your employer-sponsored plan to gain your company match
- Contribute to the IRA of your choosing up to the maximum total contribution amount
- Contribute as much as you can to your employer-sponsored plan up to the maximum total contribution amount
With these basics in mind, you can’t really go wrong. Defining the contribution amounts for your specific retirement savings plan will, of course be determined by your unique circumstances. But having a plan in place and putting aside money for the future will put you in an excellent position to enjoy a healthy income in retirement.