Katie Martin, CFA, CFP®
July 1, 2021
You know the importance of putting money away for retirement, but how do you know where you should put it? IRA, Roth IRA, 401(k), Roth 401(k) – the options can be confusing, especially when the rules around the different account types continue to evolve.
The short answer – it depends. This is one of the most common challenges I help my clients navigate, so it’s worth devoting the next two blog posts to the topic. The first step is clarifying the nuances of some of the different retirement accounts. Next month, we’ll talk about how to decide where your next dollar of retirement savings should go.
First, let’s review some of the differences between the more common types of accounts:
401(k) or 403(b)
You’re probably familiar with these as the retirement savings plan provided by your employer. Often, your company will match a portion of what you contribute to incentivize saving for retirement. With a traditional 401(k), your contribution comes out pre-tax, which means anything you contribute reduces your taxable income today. The money in the account grows tax-free, but you will pay ordinary income taxes when you take money out in retirement. You can contribute up to $19,500 to your 401(k) or 403(b) today (or $26,000 if you’re over 50), not including what your employer contributes on your behalf. The money saved in a 401(k) will ultimately be subject to required minimum distributions (RMDs), which start when you turn 72 ½.
You may already have a good grasp for how 401(k) contributions work, but one thing I find often catches clients by surprise is the impact their RMDs may have in retirement. The distributions that will be required in retirement might end up being significant, which can lead to a higher tax bill than you might expect. You might think just maxing out your contributions to your 401(k) is the best step to take for saving for retirement – and it is a noteworthy accomplishment! – but it may make more sense to leverage other kinds of retirement savings vehicles, too. Just going to leave it at that as a little foreshadowing for next month’s post.
The biggest benefit of Roth IRAs is the ability to withdraw money tax-free in retirement. This is because the contributions are made with after-tax money. So, while you don’t get a tax benefit today, being able to have money you can withdraw tax-free in retirement can be very useful. Roth IRAs also aren’t subject to RMDs, so you have more control over when money is withdrawn from the account. There are more limitations on Roth IRA contributions, though – your ability to contribute gets phased out at certain levels of income (starting at $198,000 for married filing jointly, for example,) and the contribution limit is $6000 (or $7000 if you’re over age 50.)
Even if you’re over the income limit to be able to contribute directly to a Roth IRA, you may be able to make what’s called a backdoor Roth IRA contribution. Where possible, this is a solution I try to implement with my clients to increase the amount of tax-free income they can draw from in retirement.
Roth 401(k) or 403(b)
Roth 401(k)s are relatively new (they were introduced in 2006) and combine some of the features of traditional 401(k)s and Roth IRAs. While not all companies offer them, they are becoming more common all the time. Roth 401(k) contributions are made after-tax, but the money grows tax-free and qualified withdrawals in retirement are not taxed. Roth 401(k)s have the same contribution limit as traditional 401(k)s of $19,500. (Quick note here that the $19,500 is a combined limit for all types of 401(k) contributions.)
It’s important to point out that there isn’t an income limitation on a Roth 401(k), which is a big difference from a Roth IRA. So even if you’re a higher earner, you’re still able to contribute to this account.
Hopefully, this provides a little more clarity around how some of the different retirement accounts work, but you’re probably left wondering, “what do I do about it?” Stay tuned for next month’s post where I’ll share some thoughts on how to decide where that next dollar of retirement savings should go to be working most effectively for you.
This blog post is intended for general information only and should not be construed as personalized investment, legal, or tax advice. The information is based on sources believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Statements made in this blog may be subject to change depending on revisions to the tax code, statutes, regulations, or government policy. Please consult your accountant, attorney, or financial advisor prior to engaging in any legal, investment, or tax strategy.