So you're finally out of debt, saved up an emergency fund, and are ready to start saving for retirement. The question that you have now is, what type of retirement account should you choose? An IRA, a Roth IRA or a 401(k)?
If you’re not familiar with these basic retirement account types, you may want to check out IRS Publication 590. It’s free, and it's pretty in-depth in explaining the differences between the accounts. But just to review for this article's purpose – here are the three account types:
- Traditional 401k: An employer sponsored retirement savings plan that allows a worker to save for retirement and defer income taxes on the money until withdrawal.
- Traditional IRA: A retirement savings plan that allows a worker to save and invest for retirement with pre-tax dollars. Withdrawals are taxed.
- Roth IRA: A retirement savings plan where money is invested with post-tax dollars, and are not taxed at withdrawal.
So which account type should you choose for your situation?
IRA Or A Employer Sponsored 401k?
We know that there are some obvious differences in the account types, like tax differences, but there are other non-tax related differences as well.
- The 401(k) will often offer a matching contribution from your employer: If your employer offers this, jump on it – it's an immediate 100% return!
- A 401(k) often has limited investment options: 401(k) plans will often give you only a limited choice of pre-selected funds and they're often high cost actively managed funds. An IRA will usually give you access to more low cost index funds and other options.
- 401(k) plans probably usually charge significant administrative fees: A study done by the Investment Company Institute and Deloitte Consulting found that the median employer-sponsored retirement plan charges an administrative fee of 0.72% of assets. (That’s on top of the fees charged by the funds.) By comparison IRA providers usually don’t charge any admin fees at all.
When you examine these three points, I think most people would suggest this example investment strategy.
- Put money in your 401(k) until you get the full employer match.
- Max out your traditional IRA to take advantage of its lower costs and better investment options.
- Go back to your 401(k) and max it out.
- Invest via taxable accounts.
Roth IRA or Traditional IRA?
Now if you are able to contribute to a Roth IRA or a Traditional IRA you have something else to consider. Where do you expect your tax bracket to be when you retire? Depending upon where you think your tax bracket will be when you retire, you may want to make a different investing choice.
- You think your tax rate will be the same: The ending value of your account will be the same whether you pay tax now or later (Roth IRA Vs. Traditional IRA). With all things being equal, if you expect your retirement tax rate to be the same as your current tax rate, a Roth isusually going to be better. The reason? Roth IRAs are not subject to required minimum distributions and your contributions (with the exception of amounts converted from a traditional IRA) can be withdrawn free of tax and penalty at any time.
- If you expect a higher tax rate in retirement: It’s best to contribute to a Roth. Better to pay tax at a lower rate now, than later at a higher rate.
- If you expect a lower tax rate in retirement: It’s best to contribute to a Traditional IRA. Better to pay tax at a lower rate later than at a higher rate today.
- If you have no idea what to expect, diversify: If you're not sure where your taxes will be, tax diversify and do a little of both. A lot of people do this unknowingly when they contribute to a tax-deferred plan at work, and then a Roth as well.
Have you set up your retirement strategy? What plan did you settle on? Are you going with a 401k, IRA or Roth IRA? Are you tax diversified?