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It’s the most basic question many people have about saving for retirement: “Where should I put my money?”
Because of their tax advantages, government-approved retirement accounts should be a core part of any retirement savings plan. The most common of these include 401(k)s and individual retirement accounts, or IRAs.
The wisdom of maximizing tax advantages is clear, but figuring out which type of account will provide the most benefit isn’t as obvious. And once you’ve chosen a plan, such as an IRA, you might still have choices to make. For instance, you can invest in a Roth IRA or a traditional IRA. Here’s the main difference: You pay taxes on Roth IRA contributions upfront, but not when you take your distributions; conversely, your contributions to a traditional IRA are tax deductible, and then distributions are taxed.
Consider these three factors when deciding whether to use an IRA and which type fits you best.
IRAs vs. employer-sponsored plans
In 2015 and 2016, IRA savers are allowed an annual contribution of up to $5,500 in earned income per person, per year. People 50 and older can make an additional $1,000 in “catch-up” contributions. In contrast, employer-sponsored plans allow up to $18,000 in annual contributions, with a $6,000 catch-up provision for older investors.
In addition to contribution limits, consider whether your workplace retirement plan offers an employer match, and research its investment options and fees to see whether it’s a better deal than an IRA.
>> MORE: Roth IRA vs. 401(k): Which is best?
Under most circumstances, you can contribute to both an employer plan and an IRA. However, there are income ceilings for Roth IRA eligibility. You can find more information on these limits at the IRS website. And if either you or your spouse are covered by an employer-sponsored retirement plan, there are limits on the amount you can make and still deduct your traditional IRA contributions.
Tax now or tax later
The tax treatments of traditional and Roth IRAs make them adequate for different retirement savers.
If you expect to be in a lower tax bracket when you retire, you might be better off contributing to a traditional IRA and taking a tax deduction now. If you expect to be in a higher tax bracket in retirement, consider putting your after-tax money in a Roth and taking tax-free distributions later.
To estimate your taxable retirement income, take into account your expected Social Security benefits and required minimum distributions. Traditional IRA owners must take minimum distributions starting at age 70½, while Roth owners need not take distributions.
Retirement income vs. leaving a legacy
Some people “overinvest” and have more money in retirement than they need. When they reach the age of 70½, RMDs from 401(k)s and traditional IRAs create an additional tax burden. If you think you might find yourself in this situation, you can avoid paying taxes on money you don’t need and more easily leave an inheritance for your heirs with a Roth IRA.
A Roth IRA can be an effective estate-planning tool for two reasons. First, there are no RMDs, so the balance can grow tax-free for life without loss of principal. Second, since Roth IRAs are funded with after-tax money, the proceeds can be withdrawn tax-free by you or your heirs.
Note that IRAs, whether traditional or Roth, also let the account holder establish a beneficiary. After death, this allows for a much quicker transfer of assets than going through probate. If your family is suddenly faced with bills after you pass, being able to access the money in an IRA could make a big difference.
There are many other variables that can affect how you plan for your retirement, but the process involves much more than thinking about money — it’s about figuring out what your needs and goals will be when you stop working. If you’re still overwhelmed by the options, schedule an appointment to talk with a local fee-only financial planner. Working with a professional helps ensure that you’re making the best possible decisions about your retirement funds.
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