You’ve heard it over and over: save for retirement. But knowing how to do that can be confusing, to say the least.
The main options available to the average investor are a 401(k) plan, a traditional Individual Retirement Account (IRA), and a Roth IRA.
Here are the differences:
—With a 401(k) plan, any money you contribute to your account comes from your gross earnings, i.e., before taxes. Thus, if you make $50,000 this year and put $5,000 into your 401(k), you will be taxed only on the remaining $45,000. This is the type of account that your employer can also contribute to. The catch is, as the money is invested over time and continues to grow, you will pay taxes on any amount you withdraw at retirement.
—A traditional IRA works the same way, though of course there are no employer contributions to the plan.
—With a Roth IRA, it’s just the opposite. You will be taxed on the entire $50,000 in our example, but any investments and earnings you withdraw at retirement will be tax-free.
A recent article in the Chicago Tribune put it succinctly: “The crux of the answer is that you should use whichever style of retirement savings plan lets you keep more of your money after taxes.”
But that’s still not an easy decision, because it forces you to predict not only what tax bracket you’ll be in at retirement, but what the tax code will look like 20 or 30 years from now.
Most analysts urge everyone to start with a 401(k), largely because of the employer contribution. This arrangement allows your employer to match up to six percent of whatever you contribute to the plan, automatically doubling your contributions before you even invest any of your funds.
Once you’ve maxed out on the employer match, however, you may want to find another way to diversify your retirement savings. Then you look at the IRAs.
“Most young adults have lower incomes in their early earning years than they do later in their careers and even retirement,” financial adviser Jared Parks told CBS MoneyWatch. “By using a Roth IRA now, they can take advantage of being in a lower income bracket and potentially avoid higher tax rates when it comes time to start distributing funds from their retirement accounts.”
This advice is seconded by Matt Gellene, a Merrill Edge executive, who told U.S. News, that “the longer their earnings can grow, the more potential income they may have that is never taxed.”
To confuse the issue even further, the Tribune notes, many 401(k) plans now allow you to make Roth-style contributions, that is, contribute after-tax income now to avoid taxes on withdrawals later. And it may be difficult to keep track of your investments across multiple accounts.
In general, however, the smart advice is to start with a 401(k) and contribute up to the maximum employer match. Then switch any remaining savings over to an IRA: a Roth if you have at least 20 years to retirement age, traditional if you’re closer to retirement.
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