Sometimes it feels like there are way too many options to consider when saving for retirement. Sometimes you can choose between a 401(k), IRA, deferred compensation account, a nonretirement account, or others. We get lots of questions about these different options. “Should I contribute to my employer’s 401(k)?” “They offer a match; should I contribute above that amount, just that amount, or not even that amount?” “They don’t offer a match; should I even participate in their plan, or just contribute to an IRA on my own?” “I’m maxing out my 401(k). Should I also participate in the deferred compensation plan? And how much?” “Ok, I made up my mind, but should I contribute to a Roth or Traditional?” “Can I even contribute to a Roth?” “Does the IRS consider my 2006 winnings from The Weakest Link to be current earned income?”
There are so many things to consider when deciding what type of account to use for retirement savings. Here are some of the questions you need to consider when deciding how to save for retirement, along with our thoughts.
Does your employer offer a retirement plan that has a match?
Let me start off by telling you something you’ve probably heard a thousand times – if your employer offers a match as a part of their 401(k) (or similar account) offering, you’ll be leaving money on the table if you choose not to contribute to your employer’s retirement plan. If your employer matches 100% of your own contribution up to, say 5% of your salary, if you’re not contributing at least 5%, it’s likely that you’re doing a disservice to yourself. A 100% match is basically a 100% return in year one of that contribution.
Is your employer’s retirement plan expensive?
Some employer-sponsored retirement plans are expensive. High administrative fees can eat in to your returns, and reduce your expected balance by tens of thousands (or more) of dollars over a long period of time. Most large, reputable companies offer plans that have low or no administrative fees to the employee, but if you’re not sure, check your statement, or check with your employer.
In addition to administrative fees, the individual investments within your account will likely have fees. Mutual funds have underlying fees that reduce their returns; you don’t see the fees as a line item on your statements. You’ll have mutual fund fees no matter where you buy them from, but when you’re deciding whether to use an employer-sponsored plan versus something else like an IRA, check out the expenses on the various funds offered within your employer’s plan. If there are numerous funds that have expense ratios below 1.00%, your employer offers relatively low-cost funds.
Sometimes high expenses might be justified if you’re getting a lot of advice or assistance from the plan sponsor, but typically plan sponsors are providing employees with education that isn’t employee-specific advice.
Is your employer’s retirement plan flexible?
There are many different ways an employer can make their plan flexible – more than is appropriate for a brief blog article. In my opinion, the two most important factors are what investment options your employer offers, and whether they offer a Roth contribution option. A wide range of low-cost investment options makes an employer’s plan more appealing. The Roth option is important if you want to contribute Roth dollars instead of traditional, which brings us to the next question.
Are you contributing to a Roth or Traditional account?
Within employer-sponsored plans, you might have an option to contribute Roth (post-tax) dollars as opposed to Traditional (pre-tax). When you contribute Roth dollars, that money is taxed today, and then when you take it out later in life and you meet the requirements, the withdrawal – along with any growth – is tax-free. If you expect your income taxes to be higher later in life than they are now, it usually makes sense to contribute to Roth. In other words, you’d rather pay taxes at a low rate today than at a higher rate later in life.
Often times when we run financial plans for affluent clients, we do see their projected tax rates to increase later in life when Required Minimum Distributions (RMDs) begin at age 72, and when social security or pension payments kick in. Conventional financial planning rules of thumb usually tell older folks to contribute to Traditional instead of Roth near the end of their careers, but we’ve found that Roth makes sense for a lot of our clients. Whether Roth or Traditional makes more sense for you is dependent upon lots of variables.
Without the assistance of a financial planner or tax advisor who does proactive tax planning, it’s hard to know the right decision, but it all comes down to whether you anticipate your tax rates to go up or down later in life, with one caveat – sometimes you might want to build up a bucket of Roth dollars, a bucket of Traditional dollars, and a bucket of nonretirement money, regardless of what you think is going to happen to your taxes later in life. This ensures you have a diverse set of accounts to choose from since all of those accounts have different tax treatment. This will enable you to adjust your tax plan as legislation changes in the future.
Are you saving enough for retirement?
Even if your 401(k) is expensive, doesn’t have a great menu of options, and isn’t all that flexible, it might still make sense for you to participate. Other options like IRAs have lower contribution limits, or you might make too much to experience any tax benefits from IRAs. If you need to save more for retirement than an IRA would allow, you might need to use a 401(k) or other employer-sponsored plan just to get tax-advantaged dollars into a retirement account.
Are you self-employed?
For those of you who own your own business or who are independent contractors, you have lots of options available to you depending on how much you need to save for retirement, how profitable your business is, how many other people own the business, the entity type, and whether you want to provide retirement benefits for any employees you might have. Choosing a specific type of retirement plan is a big decision and is beyond the scope of this blog article. But suffice it to say there are some options you can choose from that allow you save a lot of dollars in a tax-advantaged way, and we’d love to talk to you about your options.
What retirement account options make sense in the bigger picture?
Whatever options you have available to you, we believe you need to make these types of decisions within the broader context of your financial goals. All of the financial decisions you make are interconnected, so you can’t make any of these decisions in a vacuum. If you haven’t created a financial plan and you want to take charge of your financial future, contact us. There’s too much at stake to be unsure of your financial future.