There are a lot of buzzwords around the conversation of retirement. What does Roth mean? What is a 401(k)? What is an IRA? What can I invest in? What should be my priority list?
My first article on MBFIW discussed What Roth Means. Click the link to revisit that topic in light of this more “tactical” post. The first thing to cover is why retirement accounts have these confusing words.
Plainly put, taxes are the reason retirement is a difficult and complex subject. The investments themselves aren’t any more complex than a normal investing portfolio. It’s simply wrapping your head around the “order of attack” to start saving retirement money.
Investing without any tax shelters or umbrellas is what someone would do 50 years ago before all of these shelters were invented. There is no tax implication or benefit if you are simply “investing.”
The next type of retirement investing is what you might hear referred to as “Traditional” IRA’s or “Traditional” 401(k). When you hear the word “Traditional,” someone is usually referring to a Tax Deferred retirement account. A Tax Deferred type of account means that you pay no taxes on the money that you are investing upon the investment part of the transaction. As the investment grows and you begin taking withdrawals (in retirement), you are then taxed on the portfolio at ordinary income tax rates.
Another type of retirement account that we discussed in depth was a Roth account. This is the opposite of the Traditional accounts. You pay taxes on the contributions (up front), but when you make withdrawals (in retirement), they are tax free.
The previous two terms refer to exactly how the taxes affect the plans. These are more like the “adjective” that goes with the plan name. The plan names come from different sources, but think of them as the “noun.” These are the actual types of accounts you will use to invest.
A 401(k) and 403(b) plan are virtually the same thing. These are both plans offered by your employer, mainly with distinction only in the tax code. Not to over-simplify, but the 401(k) is usually a private company and a 403(b) is usually a government job, or non-profit job. There’s nothing particularly special about the names 401(k) or 403(b). The names come from those sections in the IRS tax code that allows the employer to offer a retirement plan with payroll deductions. It’s that simple!
A TSP is much like a 401(k) or 403(b). This is an account you can get if you are an employee of the federal government.
So let’s play with some of these combinations to show how simple the terminology is once you have a few definitions in mind. A “Roth 401(k)” would be a private company’s retirement plan where the employee pays the taxes up front and has tax-free withdrawals. Clear? A Traditional 403(b) is a tax deferred retirement account offered by a non-profit entity. Each term helps paint a picture.
Now for the fun part! Which order should you invest in? There is one question you should answer before we determine what order to begin using these accounts. During retirement, do you think you will be living on more, about the same, or less than your current income? This is important because tax deferred account are taxed as ordinary income is taxed.
Therefore, if you are early in your career and investment saving, it will be advantageous to use Roth vehicles. If you are in the middle of your career, this discussion might be a wash, and it’s smart to error on the side of tax-free in retirement and also use Roth. If you are late to the game, nearing the final decade of your career and just getting serious about saving for retirement, it might be good to use Traditional (tax deferred) accounts.
Here is the reasoning behind what I just said. If you start investing early in your life, you have a high likelihood of having a far greater income in retirement than you did in your career. This means you will have a higher tax rate. Therefore, to avoid the high tax rate, you should use Roth.
If you start investing in the middle of your career, the logic is similar to investing in the beginning. You will still likely have a higher income in retirement or perhaps a similar income to your career. Using Roth vehicles removes any risk of taxes going up over time, which is an added benefit and hedge against the future.
If you start investing late in your career, you are likely to have a lower income than when you were working. Because of this, your tax rate may actually be lower, and it may be advantageous to instead tax the tax break up front, and then pay taxes on the back side. In this scenario, begin with Traditional retirement vehicles.
The last thing you should do is decide how much you want to invest. 15% is a great investing starting point. If you can’t squeeze 15% out of your budget at the moment, try for at least 10%. The important part is to start. If you have extra income beyond 15%, by all means, continue investing past that mark! The more you invest, the wealthier you will be. Let’s put all of this mumbo-jumbo into some bulleted shorthand for clarity. Take your income, and start adding up these percents to make a retirement investing plan.
- Invest in any employer sponsored retirement plan with a match, up to the match maximum. (Choose Roth or Traditional based on your life plan.)
- Invest in a private IRA account with a broker in your name only. (Choose Roth or Traditional based on your life plan.) Invest everything you can until you hit the allowed annual maximum. Do this for your spouse as well, you are each allowed accounts and maximum investments.
- Circle back to your employer sponsored retirement plan and restart more investing above the match we previously discussed until you hit the maximum.
- Ask your investing broker if you qualify for a “backdoor IRA.” He’ll know what you are asking about and let you know if you qualify. Invest until you max that out.
- Last, you are out of tax advantaged accounts. Begin investing without a shelter until you reach your targeted retirement investments.
Most people will not make it to #5 in the list, and that is OKAY. This is simply a plan of attack that should help guide you as you decide which vehicles to invest within.
- Roth is great for young people in almost all circumstances. It loses effect as you get older, and as you enter your last working decade, Traditional accounts might be more advantageous.
- Always take advantage of your employer match. Even if the investment options stink, it’s an immediate 50-100% return on your investment.
- Individual IRA’s might be better than continuing with 401(k) or 403(b) after the match. This is simply because you have more investment options.
- Utilize tax advantaged accounts (Roth and Traditional) before doing non retirement investing.