The financial nerds out there may like this article as it is going to get a little "technical". It's also a little long. But that's mainly due to the nature of this subject, so I hope you bear with me.
In an earlier article, I cited a study by The Center for Retirement Research (CRR) that said that, for many people, especially those in their 20s or 30s, saving 15% of their gross income seems to be in the "sweet spot" in terms being able to save enough for retirement. (This happens to also be the percentage that Dave Ramsey and many others recommend.)
After reading that article, a friend of mine was thinking about how to best allocate the 15% across different retirement accounts and asked this question (paraphrased): "If we contribute the maximum to our Roth IRA, then does our 401(K) have to be Traditional and not a Roth?" (The question could also be asked vice-versa.)
The short answer is, no – if you maximize either your Roth 401(k) or your Roth IRA, neither prevents you from contributing to or maximizing the other. But there's more that needs to be discussed. A reasonable follow-up question might be: "What is the optimal way of allocating that 15% between a Roth 401(k) and personal Roth IRA accounts (or between Traditional retirement accounts)?"
If you're unclear about the distinctions between Roth and Traditional retirement accounts, take a look at this article on CNN Money.
Introducing Mike and Marge
To help address this, I'm going to introduce a hypothetical couple – I'll call them Mike and Marge (hereinafter referred to as "M & M"). Mike is a salaried employee at a medium size company that does not offer a pension plan but does offer a 401(k). Marge is a stay-at-home mom, but there is a good chance she will re-enter the workforce at some point. M & M are both in their mid -30s.
M & M want to save 15% of their annual income of $70,000 for retirement, which is $10,500. According to current IRS guidelines, M & M qualify for Roth retirement savings accounts. Therefore, Mike can participate in a Roth 401(k) at his work and receive employer matching contributions of 50 cents on the dollar for up to 5% of his gross income.
Let's pause here for a moment and consider what Mike has been given – free money! Yes, for every dollar that Mike earns and contributes to his account, his company will give him 50 cents, and the 50 cents isn't currently taxable as income and doesn't count against the contribution maximum of 5% of his gross income. That's free money that can grow through the power of compounding for many, many years – tax deferred. (Employer matching contributions on both before-tax 401(k)s and after-tax Roth 401(k)s are not taxed until distributed.)
Mike also has a Roth IRA through a financial services company. As noted above, having a Roth 401(k) plan at work doesn't limit his ability to contribute to his personal Roth IRA, or to a Roth IRA for his wife, Marge.
Since M & M have some options, here's how they might consider allocating their savings across those accounts:
Maximize his employer's match in his Roth 401(k). The first place that Mike should put his retirement savings dollars to work is in his work Roth 401(k) in order to maximize his employer's match. They showed you the money, now go get that free money! His company matches 50 cents on the dollar up to 5% of gross income (which essentially equates to 50% of 5%, which is 2.5%), so if he contributes the maximum of 5%, he is effectively saving 7.5% of his income (5% plus 2.5%). M & M are already halfway to their 15% goal!
Contribute to his individual Roth IRA. Even though Mike contributes 5% ($3,500) to his work 401(k), he can also contribute the maximum in his personal Roth IRA ($5,500). According to RothIRA.com, an excellent resource for all things Roth, this limit applies to all the IRAs an individual (not a couple) may have, either Traditional or Roth:
For individuals that are under 50 years old the limit on contributions to a Roth IRA is $5,500. This amount is the total that can be contributed per year across all IRAs you may have with multiple providers (these limits are the max you can contribute across all IRAs, including both Traditional or Roth IRAs).
For example, you could contribute $2,500 to a Roth IRA with one provider and $3,000 with a second provider. You cannot contribute $5,500 to the first Roth IRA and $5,500 to the second provider. Your total contribution limit is $5,500 for all accounts for the tax year.
If Mike contributes the maximum allowed to his personal IRA ($5,500), which is 7.85% of his gross income, he will exceed his goal of 15% (7.5% plus 7.85% equals 15.35%). Done.
Now go and git 'er done!
To implement this strategy, Mike would need to open a personal IRA if he didn't already have one. (It can be a Roth or Traditional IRA, but let's assume a Roth for now.) I like keeping things as simple as possible and having multiple accounts, with multiple different investments in each account, does increase complexity. But if you can keep it down to only 2 or 3 – perhaps a 401(k) and a Roth IRA for each spouse – you should find that to be manageable. And you always have the option of consolidating some of these accounts sometime in the future (as long as it's Roth to Roth or Traditional to Traditional).
Another way to keep things simple is to invest in "single fund" portfolios that are right for your age, long term goals, and risk tolerance. Examples are Vanguard's Target Retirement Funds and Lifestyle Funds, or Fidelity's Freedom Funds. This will help reduce the number of investments you have to manage across multiple accounts. They're not for everybody so you should research them diligently before making any decisions.
At this point you may be wondering, "Why wouldn't Mike just make additional contributions to his Roth 401(k). He can do that with payroll deduction, and it keeps his savings all in one place." Well, that's also a very good question. There are pluses and minuses with both options and it really comes down to how you weight them in your own individual situation and perspective.
Here is a short list of the major strengths and weaknesses of the Roth 401(k) and the Roth IRA. When you weigh those two alternatives for saving beyond the minimum required to get the employer match in a 401(k), I think the Roth IRA has the edge:
- Higher contribution limits (in 2015, workers can deposit up to $18,000; if you're age 50 or older you can add another $6,000 to that amount due to catch-up provision)
- May have limited investment options (and sometimes limited quality)
- May have increased fees due to incremental custodial and administrative costs (on top of the investment funds themselves)…
- …however, government regulations require employers to vet investment options and be transparent about fees
- Account will probably stay with your employer when you leave (it's still your money, of course)
- Transferring funds from one 401(k) to another is allowed, but can be difficult to execute
- No additional benefits after maximum matching contribution level is met
- Payroll deduction is a big plus (enforces saving discipline)
- Can borrow from it (I don't personally view this as a big benefit, but others may)
- The funds in a 401(k) are protected if you ever find yourself being sued or filing for bankruptcy
- Qualified distributions are tax free
- Income-based eligibility requirements (if you make too much, you have to contribute to a Traditional IRA)
- Contribution limit in 2015 of $5500 per individual ($6500 with catch-up provision)
- Investment options are virtually unlimited; some at low or no up-front commission to purchase
- The onus is on you to vet investment options for consideration
- Option to build and manage a very low-cost investment portfolio
- Option for active management should you so choose (I prefer a fiduciary management relationship with a Registered Investment Advisor based on a low percentage of assets fee structure rather than a Registered Representative who works on commission)
- No concerns about employer or job changes
- IRAs of the same type (traditional or Roth) can be easily combined
- Can be used to consolidate disparate Roth 401(k) accounts in the future using the "rollover" provision
- Can use direct deposit to help with savings discipline
- IRAs do not offer the same level of creditor protection as a 401(k) plan (some states protect up to $2Mil); plus, inherited IRAs are totally accessible to creditors
- Qualified distributions are tax free
If I were to summarize this comparison, I would say that, apart from the employer contribution to the Roth 401(k), which makes it the clear first choice for your retirement savings up to the maximum the employer will match, the two options shake out this way for additional contributions:
- Roth 401(k) – higher contribution limits, typically with limited investment options, possibly at higher cost, with significant creditor protection.
- Roth IRA – lower contribution limits with more lower cost options, but with limited creditor protection. (Both are after-tax contributions but offer qualified tax free distributions.)
So, at a minimum, I like to see people contribute to their retirement plan at work up to the limit of the company's matching program, if there is one. From there, additional (un-matched) contributions could be made to the 401(k), but I recommend you make them to your Roth IRA up to the contribution maximum (currently $5,500 for those under-50 and $6,500 for those over-50 based on the "IRS Catch-Up Provision".)
It turns out this is very consistent with Dave Ramsey's investing philosophy:
In Baby Step 4, you'll invest 15% of your income. If your employer matches your contributions to your 401(k), 403(b), TSP, then invest up to the match. Next, fully fund a Roth IRA for you (and your spouse, if married). If that still doesn't total 15% of your income, come back to the 401(k), 403(b) or TSP.
Want to save more than 15%?
M & M were able to hit their target of 15%, but what if they weren't, or if they decide to increase their savings percentage – what should they do next?
Open and/or contribute to a spousal Roth IRA for Marge. In this example, M & M can hit their savings goal percentage using just Mike's 401(k) and his IRA. But let's assume that for whatever the reasons (perhaps playing a little catch-up) M & M want to up their total savings percentage to 20%. In that case, they essentially have 2 options: 1) make additional (unmatched) contributions to Mike's work 401(k) up to the maximum of $18,000; or, 2) contribute to a spousal Roth IRA for Marge up to the maximum of $5,500.
In order to hit a savings goal of 20%, M & M need to save an additional 5% or $3,500 per year. Either option gives them the ability to do that. So, it comes down to the differences between the two alternatives that I listed above. One advantage to making those contributions in Mike's 401K versus a new Roth IRA for Marge is that it keeps things simple – one 401(k) and one IRA.
Apart from that, I'd opt for the spousal IRA. (So, I guess you could say that I am espousing a case for the spousal IRA in this case.)
By the way, according to the IRS, to open a spousal IRA and make a contribution, you must meet the following requirements:
- You must be married.
- You must file a joint income-tax return.
- You must have compensation or earned income of at least the amount you contribute to your IRAs.
But remember – and this is very important – you can open a spousal IRA even if you have only one earned income!
If M&M contribute the maximum of $5,500 to Marge's personal Roth IRA, their total annual contribution to their 3 retirement accounts will be approx. 23% of their annual income, well over their 20% target. If they actually wanted to save more, they will have a lot of room in Mike's Roth 401(k) before they would hit the maximum of $18,000 ($14,500, to be exact).
What about Traditional 401Ks and IRAs?
This article has mostly been about Roth accounts (401Ks and IRAs). That's because they make the most sense for the majority of people. However, some have been (or will be) saving in "Traditional" accounts. Traditional in this sense means contributing pre-tax dollars that grow tax free, but are taxable upon withdrawal in retirement. The Roth versus Traditional IRA/401(k) is an interesting discussion that I will touch on here and may get more in-depth in a future article.
You can always contribute to a traditional 401k or IRA up to the annual contribution limits as long as you have enough income. However, there are income limits dictating whether you can contribute to a Roth account or not. The limits depend on your modified adjusted gross income, or MAGI (and that's NOT the wise men that traveled to the Nativity.) If you can't contribute directly to a Roth account, you can contribute to a traditional 401(k) or IRA.
One of the main arguments for the Roth IRA, especially the advice to consider converting traditional accounts into a Roth (conversion is a big topic for another day), is predicated on the belief that tax rates will go up in retirement.
My personal IRA is a Traditional one. That's because the Roth didn't exist when I first started saving in a 401(k) and a personal IRA 30 years ago. Later, when the Roth came along, I didn't qualify due to my income level (the limits were lower then.) Later, I considered converting and ran the numbers and it just didn't make sense for me. If it turns out my tax rates are much higher in retirement I may have some regrets, but at least I've gotten to use money that I would have otherwise had to give to the IRS for 30 years!
There's no denying that we live in a world that is economically very different than it was 5 or 10 years ago. And all other things being equal – taxes will probably increase, at least for the more wealthy among us. But for most of us, the tax rate in retirement has gone down, because a retiree's income is usually significantly reduced. (And seriously, if your income isn't reduced in retirement, taxes may be the least of your worries.)
Muddying the Water a Bit
Now having said all that, I am going to muddy the water a little bit. Although the money M & M contribute to their Roth accounts does grow tax free and will remain that way when they withdraw it, keep in mind that they are contributing "after tax money." You may be thinking, "So what, they pay the taxes once on a small sum, then they're free from taxes from there on out – no big deal."
You're right, but let's look at this a little closer. If Mike funded a Traditional (tax-deductible) IRA with $5,500 instead and has a marginal tax rate of 15% based on income of $70,000, all he would need is the $5,500 because it is deductible. He doesn't have to spend anything more on taxes, at least not now.
But with a Roth (non-deductible) IRA, Mike will actually need $6,325: $825 to pay the 15% in taxes and $5,500 to fund the Roth IRA. That $825 is now gone forever into Uncle Sam's coffers along with the growth and income it could have earned for him over the years.
If Mike funded a deductible (Traditional) IRA, instead of a Roth, he would still have the $825 to invest, unless it was already spent for something else. Of course, since it was retained as part of total income, it would be subject to the 15% in taxes. After paying taxes on it, Mike would actually have $700 left to invest.
That's not a huge sum, but hold on. Since the average annual return on the S&P 500 for the 40 years from 1975-2014 was 8.88%: $700 invested each year for 30 years (when Mike will be 65) @ 8.88%= $71,000. Of course, if Mike doesn't invest those tax savings and just spends the money (as most people do) he'll lose these earning and the Roth may have been a better choice.
If he invests in the Traditional IRA, he will have to pay taxes later on – perhaps when he is in a lower tax bracket. But he would (theoretically) have $71,000 more in savings since we are assuming that he invests his tax savings of $700 each year with a Traditional IRA and would not with a Roth.
We also need to keep in mind that he will pay taxes at his "effective" rate, which could be less that his current 15% marginal rate, or depending on future tax laws, it could be more. If it is at 12%, he will have to pay that percentage on any amounts he withdraws from the $71,000. If the money is invested in a Roth, there are no taxes due when he withdraws from it.
So, depending on your individual situation, using the Roth IRA option as the first choice after contributing all you need to maximize your employer match in your 401(k) will make the most sense if your income is low enough that you are paying little or no income tax. If your income is high and you are in a relatively high tax bracket and you plan to save the money you would not have to pay if contributing to a Traditional IRA, considering going that route instead. Then, go back and fund your 401(k)-type plan.
Need some help running the numbers? Try using a good online calculator for comparing Roth versus Traditional IRA contributions.
What about Deferred Annuities?
Deferred Annuities are savings vehicles that can grow tax-free (until you need the money) outside of an IRA or some other retirement account. They are typically used as the final destination for savings once you have maxed out all your other retirement accounts – IRAs, 401(k)s, etc. You save money now, the money grows tax-deferred until you retire, then you receive a taxable "guaranteed" income stream for life.
These products are typically sold by insurance companies. They can be very complex and often carry high sales commissions and management fees. Someone who is relatively wealthy who wants to save for retirement well beyond what can be done with more conventional vehicles may find them useful, but for most of us, they aren't necessary. Just use your 401(k)s or 403(b)s and IRAs and you should be fine. Here's what Dave Ramsey has to say about that strategy:
The bottom line here is that while a guaranteed income is great, your earnings potential is much greater with mutual funds. Stick to a simple plan: Invest 15% of your income in mutual funds through tax-advantaged accounts such as your 401(k) or a Roth IRA.
If you open an IRA through an insurance broker, they may try to sell you an annuity product inside the IRA account. I am not anti-annuities (they definitely have their place), but such an arrangement is not necessary as the growth and income from the IRA is already tax-deferred or tax-exempt, depending on whether it's a Traditional or Roth IRA. Plus, you can always convert an IRA to an annuity when you are in retirement, or even purchase one with non-IRA savings if you need to.
Just do it
I don't have a crystal ball, so I think your best plan is to diversify your retirement savings between different types of accounts rather than locking yourself into a specific scenario that you are convinced will play out in the future. For some that may mean having both traditional and Roth accounts, as well as other retirement income generating vehicles such as rental real estate, annuities, or even a small business, if you are able.
Not matter what; the most important thing is to be saving something, at least 10 to 15% if you're young. It matters less whether it's in a 401(k) or IRA, Traditional or Roth. If you do, it will grow tax free or tax deferred until you need it in retirement, and that can help you grow a substantial nest egg. Once you make the decision to save, and have those different options available to you, it becomes a more important decision based on your current tax situation and what you think it will be in the future.