You hear it all the time. On your TV, in your car, even on your computer. They’re all asking the same thing, “Are you saving enough for retirement?” I’m sure over the years that question has faded into the background. Don’t get me wrong it's an important question, maybe even the MOST important question on your path to retirement, but I can think of another question that can be just as important, but gets asked far less. That is, “Where is my retirement money going?” In other words, what type of retirement accounts are my savings going into and why. Maybe your company offers a 401k plan so you put your savings in that. Or maybe you listened to your parents and opened an IRA. Maybe you’re ahead of the curve and have both, or you might be reading this and have neither. The bottom line is where your money is going can be just as important as how much you save.
Let’s start with your 401(k)…
A 401(k) is an employee-sponsored retirement savings account. The money that goes into a 401(k) is taken out of your income before taxes, therefore, it is called pre-tax money. But don’t think you’re off the hook from the IRS just yet. They’ll end up getting their share when you withdraw money from your account, preferably after age 59 ½ otherwise you’ll be hit with a hefty 10% early withdrawal penalty.
Let’s stick with contributions for now, though. One of the best things about a 401(k) plan is not only can you contribute savings in pre-tax dollars, but your employer can also contribute money to your account. Some generous employers may even match around 4-5% of your salary. It’s like free money. This is why 401(k)s are so popular with employees that work for a company that offers this benefit.
Now on to your IRAs…
IRA stands for individual retirement account and comes in many different forms, but for the sake of time were just going to put them into 2 categories for now: Traditional IRAs and Roth IRAs.
Traditional IRAs are not so different from 401(k)s in the sense that the money that you contribute is also in pre-tax dollars. So to the IRS, it looks like that amount was wiped clean from your income. Just as with a 401(k), you will only be taxed on the money that you withdrawal from your Traditional IRA account. Again, preferably after you are 59 ½ so you are not hit with that 10% penalty. The good news with a Traditional IRA is that anyone can open an IRA as long as they are younger than 70 ½.
Don't forget about Roth IRAs...
Roth IRAs are a slightly different animal from the previous two. Instead of contributing your savings in pre-tax dollars, Roth IRA contributions are made in after-tax dollars. Meaning that the IRS will have already taken their share of the amount that goes into your Roth. This might sound like a bad deal at first glance, but it is actually a great deal for savers because it allows that money to grow tax-free all the way to retirement. The only catch is that technically you can only contribute directly to a Roth IRA in 2016 if you make less than $116,000 if you are single or $183,000 if you are married.
Okay, now where exactly am I supposed to save?
Now that you have a basic understanding of these three types of retirement accounts, I want to try and make some sense about how you should utilize them when saving for retirement. I like to think of savings in terms of a hierarchy so that I have a plan for every additional dollar that I make after all of my expenses are paid. The first two, and arguably most important, levels in the hierarchy involve building your emergency reserves and cash balance for any upcoming expenses. You can think of this as your “In case the income stops” and “Down payment” funds.
We’ll focus on these another day because they are extremely important, but today I want to focus your retirement savings and the steps that should be taken to utilize your various retirement accounts. If you are reading this, I am going to assume that you either work for a company that currently offers a 401(k) plan or will in the near future. If that is the case, then your additional savings beyond cash should go towards your 401(k) with the amount that your employer is willing to match. If they are willing to match a flat 4% of your salary, then contribute that amount. Maybe they will match 100% of the first 3% and 50% of the next 2%. In that case, it would be wise to contribute 5% of your salary to your 401(k) account. After all, as I mentioned earlier this is kind of like free money that you will thank yourself for later on in life, but that’s enough with the math for today.
At this point, you may be thinking, “Shouldn’t I just go ahead and max out max out my 401(k)?” The answer could be yes, but only if you/you and your spouse don’t qualify for a Roth IRA. If you do qualify, that is where your additional savings should go. So every remaining dollar that you plan to save after you have MATCHED (Not Maxed) your 401(k) should go into your Roth, up to the maximum contribution amount. As I said earlier, money in this account will grow tax-free all the way to retirement.
If you are an avid saver you may have some money left over after you have matched your 401(k) and maxed your Roth. This is when you should try to max out your 401(k) with your remaining savings. This is where a Traditional IRA would be funded only if you did not have a 401(k) and your income exceeded the threshold to contribute to a Roth IRA.
If you’ve made it this far, congratulations! You’re well on your way to answering the question that all of those TV commercials and radio ads keep asking. If you're still interested in learning more, click below.