Today, we have so many choices for our retirement savings that it can be difficult to choose which sort of account to contribute to. If you are fortunate enough (as many are) to have more than one type of retirement plan available to you, in what order should you contribute to the accounts? Right now, at the beginning of a new year, is an excellent time to start with retirement savings.
Qualified Retirement Plans
First of all, many folks who are employed by a company have some sort of tax-deferred, qualified, retirement savings account available. These accounts go by many names – 401(k), 403(b), 457, and deferred compensation. These accounts are collectively referred to as qualified retirement plans, or QRPs. QRPs do not include IRAs – this is another type if retirement savings account with some different rules. A QRP account is a good place to start when contributing to retirement savings. For the purpose of clarity, when I refer to a QRP, I am referring to all of these types of accounts (401(k), 403(b), 457, etc.). Understand, though, that unless I specifically include them, reference to QRPs does not include traditional or Roth IRA accounts.
If your employer matches your contributions, you should definitely choose the QRP as the place to start with your retirement savings contributions. For example, your employer may match your contributions to the QRP at a rate of fifty cents per dollar for the first 6% that you contribute to the plan.
I understand that if you’re math-averse that last sentence just came out sounding like Charlie Brown’s teacher – so here’s an example: If you make $50,000 per year and you contribute 6% (which is $3,000) to your QRP, the employer matches that amount fifty cents per dollar, or $1,500. At the end of the year you’ll have a total of $4,500 contributed to your retirement savings account. So you can see the reason why this is an excellent place to start your retirement savings. With the fifty cents per dollar match, you’re making a 50% return on your money, even before you invest it in the market! An additional bonus is that the contributions you make are pre-tax, so they’re actually costing you less in the long run.
To illustrate, the $3,000 we used in the example above would actually only decrease your take-home pay by approximately $2,250 for the year if you were in the 25% income tax bracket ($3,000 x 25% = $750, $3,000 – $750 = $2,250). So, in other words, when you include the employer match, you are actually doubling your money when you contribute to this account at this level.
After you’ve contributed up to your employer’s matching amount in your QRP, you should begin contributing your next retirement savings to a Roth IRA.
The Roth IRA
A Roth IRA is a retirement savings account that allows you to contribute, for 2015, up to $5,500 per person, plus a $1,000 catch-up provision for folks over the age of 50. You can open an account with a discount brokerage, a mutual fund company, insurance company, or at your local bank. Some of the unique features about a Roth IRA include the following:
1. Once you’ve contributed funds to the account, qualified withdrawals of the contributions and the growth of the account will be tax free. That’s right, tax free. The qualifications aren’t that difficult to live with, either – you can begin qualified withdrawals in the year you reach the age 59½.
2. Your contributions are available to you. You can withdraw the contributed amount (but not any growth of the account) at any time you wish, for any purpose, with no tax consequences. The growth of your account (investment gains, dividends, and interest) would generally be taxed and/or penalized if taken out before you reach age 59½. (Certain other qualified withdrawals may be exempt from taxation, see below.)
3. The entire account may be withdrawn for other qualified purposes prior to retirement, as well. Among these qualified purposes are: purchase of a first home, education expenses, or health-care expenses.
You have until April 15, 2015 to make a contribution to a Roth IRA for 2014. Make sure your broker or custodian understands that this contribution is for the year 2014. Once you’ve maxed out your 2014 contribution, you can begin maxing out your 2015 contribution to the Roth IRA.
For example, Dick earns $50,000 and Jane earns $30,000, and their employers match fifty cents on the dollar for the first 6%, the first step is to contribute that 6% to each of their plans. This comes to a total contribution to Dick’s and Jane’s accounts of $4,800 (6% of $80,000). Then each of them can contribute $5,500 to Roth IRAs, for a total of $15,800 being contributed for the household ($3,000 plus $1800 plus $5,500 plus $5,500 equals $15,800). Plus, the employers’ matches of $1,500 and $900 goes into their accounts as well, for a total retirement savings set-aside of $18,200 for the year.
Back to the QRP
Thirdly, you should make additional contributions to your employer’s QRP, up to the limit allowed by your employer or by law. For 2015, the maximum amount that you can contribute to a 401(k) plan is $18,000, and there’s a catch-up provision amount of $6,000 for folks over the age of 50. This is a pretty high limit, $24,000, to set aside in retirement savings.
The following options may not be applicable to your situation, but I list them for the sake of education:
Traditional IRA – if you don’t have access to an employer-sponsored QRP like a 401(k), you may want to reduce your tax burden a bit by contributing to a traditional IRA. The limits on contribution amounts are the same as described for Roth IRAs, so this can be a significant amount to set aside to reduce your taxes. Keep in mind, though, that you can only contribute the maximum amount in either a Roth IRA or a traditional IRA, or a combination of the two. In other words, the maximum contribution limit of $5,500 for 2015 (plus the $1,000 catch-up) is for ALL IRA contributions, whether traditional or Roth.
Non-qualified plans – many employers offer savings plans that go above and beyond the QRP limits. Each plan is different, so you’ll want to check the provisions to determine if the plan is appropriate for you.
Employee Stock Purchase (or Ownership) Plan – also known as ESPP or ESOP, these plans typically have a provision for controlled purchase of your employer’s stock at a discount. Assuming that you are not over-exposed to your employer’s stock (rule of thumb: no more than 5% in any single company), this may be a good place to contribute some retirement money. Keep a close eye on your exposure to this single company, as well as your company’s future prospects. Remember Enron?
College Savings Plans – after you’ve funded your retirement, consider placing some money in a 529 plan or Coverdell Education Savings Account for your child’s or children’s education. In many states, these contributions are tax-deductible.