There are so many options available when you are deciding where to save money for retirement. You have pre-tax accounts like your employer’s 401k plan that give you a tax break today to contrast against Roth retirement accounts that have you pay tax today but never again. With the alphabet soup of retirement accounts floating around: IRA, 401k, 403b, SEP IRA, and so on, how do you decide where to put your money first?
Pick a Retirement Account for Your Personal Situation
The problem with picking a place to start your nest egg is your situation is going to be different than your co-workers situation which is going to be different than his neighbor’s situation. There are general themes that ring true with almost every person that is trying to save for retirement, but when you dig into specifics a lot can change.
Which retirement account is best for you to max out your contribution to first is dependent on several factors:
- How much you want to save
- What tax bracket you are in today
- What tax bracket you will be at retirement
- How much control you want over your retirement options
Let’s take a deeper look at these factors and how they change your retirement options.
How Much to Save for Retirement
If you have a large income and live well below your means, you might have $20,000 or $30,000 each year to dedicate to your retirement savings. Having a large pool of money means you need to use multiple types of accounts to save for retirement simply because of the contribution limits on all of the available retirement accounts. On the other hand if you have only a few thousand dollars to save, you can use almost any account to save for retirement; the other factors become more important in your decision.
Your Current Tax Bracket
If you are in a high tax bracket you are probably looking for any way possible to reduce your tax bill. Saving money in a tax-advantaged account like a 401k can take a nice chunk out of your taxes owed while still saving for retirement. Just remember you will be paying tax on your nest egg during retirement if you don’t pay tax today.
Your Future Tax Bracket
This is where things get tricky. If you anticipate being in a high tax bracket during retirement and are in a low tax bracket today then you should go with a Roth IRA or Roth 401k for your retirement savings. You will pay taxes at your lower rate today and never pay income tax on the nest egg again. If you anticipate being able to drop your income down significantly during retirement (and thus fall into a lower tax bracket), then avoiding tax today makes sense. You’ll pay the tax eventually, but at a low rate. The problem you have to figure out is how to know what your tax bracket will be in the future, and that just isn’t easy to do.
Your Knowledge of Investing and Desire to Control Your Options
With more power and control of your investment options comes more responsibility. If you stick with your employer’s 401k plan you will have limited mutual fund investment options. Some see this as more simple and easy to handle; others see it is a limiting factor and want more options. Depending on which camp you are in will determine which account to go with. Other options like IRAs greatly increase your investment options.
Retirement Saving Options
Taking the above factors into consideration, which account is the best for your situation?
Your Employer’s 401k Plan
If you want an easy plan with limited control over your investment options, stick with your employer’s 401k. Your contributions automatically come out of your paycheck which makes investing easy and you get a tax break today. Plus your 401k has one of the highest contribution limits available of all the retirement accounts.
A Roth IRA
If you are in a lower tax bracket now than you anticipate being in during retirement, paying tax now is a great choice. A Roth also makes sense if you are indifferent about paying tax now vs. later and only have a few thousands dollars to contribute. The contribution limit is $5,000 (add $1,000 if you are over age 50).
A Traditional IRA
If you know you want to save a chunk out of your tax bill, a tax-advantaged account like a Traditional IRA is a great choice. If you don’t like your employer’s investment options in the 401k plan, you can open an IRA and get the same tax break with better investment options. The contribution limit is the same as a Roth IRA.
A SIMPLE IRA, SEP IRA, or Solo 401k
If you have substantial income and are limited in your retirement account options due to that income, you can consider opening an alternative type of IRA or 401k that is associated with running a business. The contributions limits are usually much higher for these business-income oriented accounts.