I am asked a lot of questions about retirement: Where should I save for retirement? Should I use a 401(k) or a Roth IRA? Can I do both? What’s a Roth 401(k)? How do I find out about my company match? I have a 403(b), what’s that?
These are all great questions! Today I want to break down all these ways to save for retirement and which ways might be best for you.
What’s the difference between a 401(k) and a Roth IRA?
A 401(k) is an employer-sponsored retirement plan. Contributions are deducted from your paychecks before your company takes out taxes. This is known as a pre-tax contribution.
A 403(b) is very similar to a 401(k), but this type of account is for employees at nonprofits and government agencies.
IRA stands for “Individual Retirement Account.” You can have any type of IRA — a Roth IRA, traditional IRA, or Rollover IRA — at any brokerage firm, and it is not tied to your employer.
With a Roth IRA or Roth 401(k), it means that you pay taxes on your contributions up front. That means you receive your paycheck and then you make a contribution to your Roth IRA. You already paid taxes when you received your paycheck, so you’re funding your Roth IRA with post-tax contributions.
By contributing to a 401(k) today, you get a tax benefit this year and then your contributions grow tax-free. However, when you withdraw the money in retirement, you have to pay taxes on your distributions.
A Roth IRA works the opposite way: You pay the taxes up front but then the money grows tax-free. When you withdraw the money in retirement, you don’t have to pay taxes.
Take Advantage of Free Money
The best way to start saving for retirement is by taking advantage of your company match. Some employers offer a company match and some don’t, but it’s worth calling up your human resources department or reviewing your company benefits package to see what your company offers. Always contribute enough to your 401(k) to get your full company match.
For example, if your company matches 50% of the first 6%, then you want to contribute at least 6% of your salary so your company will contribute an additional 3% of your salary. This is one of the few times in life where you can get free money — don’t pass it up!
It All Comes Down To Taxes
Once you’re contributing enough to earn your full company match in your 401(k), then it’s time to look at your tax bracket. The higher your tax bracket, the bigger tax benefit you receive for your 401(k) contributions.
If you’re in a high tax bracket, you’ll probably want to contribute the maximum to your 401(k), which is $19,500 per person for 2020. You deduct 401(k) contributions from your taxable income, meaning that if you earn $200,000 but contribute $19,500 to your 401(k), then you’ll only pay taxes on $180,500. However, you’ll have to pay taxes on distributions from your 401(k) in retirement.
If you’re in a lower tax bracket, it might make more sense to contribute to a Roth IRA — especially if you think you’ll be in a higher tax bracket in the future. Since you fund your Roth IRA with after-tax dollars, you pay taxes on that income at your current tax rate, and you will not have to pay taxes on distributions in retirement. (There are also some clever ways to hack your Roth IRA in pursuit of other financial goals.)
If your company doesn’t offer an employer match on your 401(k), you might want to skip it and head straight for the Roth IRA. You can contribute a maximum of $6,000 per year to a Roth IRA in 2020.
Can Anyone Contribute to a Roth IRA?
No. First, you have to have earned income to contribute to a Roth IRA. If you are a full-time student and you don’t earn income from a job, then you can’t contribute to a Roth IRA.
Also, only people whose incomes fit within certain limits can qualify. If you are single and earn more than $124,000 per year, you can’t contribute the maximum $6,000 to a Roth IRA. Once you earn more than $139,000, you’re not eligible to contribute to a Roth IRA at all.
If you are married and you and your spouse have combined incomes of more than $196,000 per year, you can only contribute a limited amount to a Roth IRA. If you earn more than $206,000, you cannot contribute to a Roth IRA at all.
What happens to your Roth IRA when your income grows beyond those limits? Read more.
Isn’t it always best to contribute to a Roth IRA?
Not necessarily. Some people make the argument that tax rates will increase in the future, so if you’re young, you should always contribute to a Roth IRA or Roth 401(k) because you will pay more in taxes later. But in truth, we don’t know what tax rates will look like in the future.
Generally, I think having some tax-deferred money in a 401(k) or IRA and some money in a Roth is a good thing, because it will allow you to have different tax buckets to pull from in retirement. The higher your current tax bracket, the more I encourage you to contribute more to a 401(k), whereas if you’re in a lower tax bracket, I’d encourage you to contribute more to a Roth IRA.
Don’t Wait! Just Start!
The biggest mistake I see Millennials make is to wait to start saving for retirement. Some people won’t start a Roth IRA because it takes more effort to open the account and it’s easier for them to just sign up for their company 401(k). If that’s you, then do that! Sign up for your 401(k)! And if you’re already contributing, then increase your contributions by 1%! Small changes add up to big results over time. The most important thing is to start.