Retirements savers today have many options to choose from when it comes to opening a retirement savings account or participating in a company-sponsored plan. But it can be difficult to know which type of plan is right for you, especially if you have access to an employer-sponsored retirement plan.
This breakdown of the major types of retirement plans and accounts can help you to determine the path that you should take on your journey to a secure retirement. Use it to review whether you have the right mix of IRAs and 401(k)s in your portfolio going forward. Decide whether this is the year you should be thinking about opening a different type of account.
For each type of account, whether IRA or 401(k), you also need to decide whether you need a Roth or regular version. Your tax status and other issues will determine which of these are open to you. You also need to think about whether you want to take the tax deduction now (a traditional account, opened with pre-tax employment income) or be able to withdraw your money tax-free in retirement (a Roth account, opened with after-tax income).
Traditional vs. Roth IRAs: Which Is Best for You Now?
There are two types of individual retirement accounts (IRAs), traditional and Roth. In 2016, the total amount you can contribute to an IRA (Roth and/or traditional) is $5,500, plus an additional $1,000 if you are age 50 or above.
Traditional IRAs allow you to make tax-deductible contributions each year that then grow tax-deferred until retirement. All income that you draw from them once you have retired is then taxed as ordinary income. There is an income phaseout schedule for this deduction if you participate in an employer-sponsored retirement plan and your income is above a certain level; your filing status is a determinant, too. (Read the specifics here.) However, this limitation only applies to traditional IRAs.
With a Roth IRA you make nondeductible contributions and then take out tax-free distributions at retirement. Roth IRAs don’t have the income threshold limit because their contributions are nondeductible. However, there is an income phaseout schedule for their use that prevents high-income taxpayers from investing in them directly. (Check here for the specifics.) Fortunately, those with incomes above the phaseout schedule can make a nondeductible contribution to a traditional IRA and then convert this amount to a Roth IRA, because no income limit is applied to conversions (see the discussion of backdoor conversions, below).
As you undertake a financial planning review, the choice you have to make is whether you need the tax deduction that you get with traditional IRA contributions – or you prefer to receive the tax-free distributions at retirement that a Roth IRA provides. You may want to speak with a tax advisor to find out which choice is best for your current situation. If you are in your peak earning years, for example, it may be better for you to make deductible contributions to a traditional IRA now. You can always convert it to a Roth IRA at retirement when you are likely to be in a lower tax bracket. Another consideration is that traditional IRAs mandate that you take required minimum distributions after age 70½ (see below); Roth IRAs do not.
If your income is too high for you to make a direct contribution to a Roth IRA, you have another option to fund your account: a backdoor conversion. This can be done in any year when your income is too high to make a direct contribution. If you have been contributing to a Roth IRA for the past few years and get a raise at your job that makes you ineligible to make further direct contributions, you can continue to fund your Roth using this strategy. To determine if your income is too high, this IRA calculator will help you.
Two Types of 401(k) Plans
If your employer offers it, a 401(k) plan is another excellent way to save for retirement. The contribution limits are much higher than for IRAs; in 2016, you can contribute the lesser of 100% of your earned income or $18,000 to a 401(k) plan, and those age 50 and above can contribute up to $24,000.
Both traditional and Roth 401(k)s are available with tax treatment similar to traditional and Roth IRAs. (Contributions to a traditional 401(k) are in pre-tax dollars; those made to a Roth 401(k) are in after-tax dollars). However, there are no income limits of any kind for plan participants. You can make the maximum possible contribution to these plans regardless of how much you make. Therefore, if your income is too high for you to make direct Roth IRA contributions and your employer offers a Roth option in its 401(k) plan, you can simply make contributions to that instead. (For more, see 401(k) Plans: Roth or Regular?)
Another 401(k) advantage: Your employer may make matching contributions that you can receive as long as you satisfy the plan’s vesting requirements. (These typically require that you work for the employer for a set number of years before you can take all of the matching contributions with you when you leave.) Even if you have IRAs, it makes sense to contribute to a 401(k) to get the full employer match. Just be aware that matching contributions are usually traditional contributions, even if you are participating in a Roth plan. That means when you take distributions, a portion of each will count as taxable income in accordance with the amount of matching contributions in the plan.
If the number of investment options in your 401(k) is limited, you may want to discuss diversifying your retirement portfolio with your financial advisor. IRAs, for instance, typically offer a wider range of choices.
Looking Ahead: Considering RMDs
Traditional IRAs – and both traditional and Roth 401(k)s – also require account owners to begin taking required minimum distributions (RMDs) on April 1 of the year after the year in which they turn 70½. RMDs from traditional IRAs and 401(k)s are taxed as regular income; an RMD from a Roth 401(k) is not taxed.
If you don’t want to take these distributions, consider converting those accounts into a Roth IRA, which doesn’t have RMDs (and allows your money to keep growing for the rest of your life). However, keep in mind that you will likely pay tax on the entire conversion balance in the year that it is made. You may be wise to convert your other retirement plan balances into a Roth IRA over a two- or three-year period in order to keep from going into a higher tax bracket. Again, it’s probably a good idea to consult a tax or financial advisor on this issue so that you can clarify the tax hit and maximize your tax savings.
The Bottom Line
The right type of retirement plan or account for you will depend upon several factors, including your current and projected future income and tax bracket, your retirement goals and objectives and your time horizon. Setting aside time annually to look at your accounts and their performance will allow you to change course, if necessary, and keep your retirement savings on track.
For more information on retirement plans and accounts, visit the IRS website and download Publications 590 and 575.
You may also be interested in Roth 401k vs. Roth IRA: Is One Better? and Traditional and Roth IRAs: Which Is Better for Taxes?