The world has changed for retirees as the number of U.S. workers covered by a defined-benefit pension plan has declined steadily over decades. For many people, the simpler days when you might expect to reach retirement in good standing and start collecting a monthly pension check are gone.
Today, it's essential for workers to participate in and contribute to their own retirement plans. While Social Security is a valuable resource, most people will find it isn't enough to sustain their pre-retirement lifestyle after they stop working.
The saving and investing you do while you're working will likely play a significant role in your financial life in retirement. So, it follows that the earlier you get started, the better. The key is to be realistic, and build a plan you can follow.
Start by creating a disciplined, prudent savings plan that defines your retirement goals and includes a monthly savings amount. To help understand how much you might need to be putting away, you can use a retirement calculator or get more help by working with a financial planner.
The next step is to figure out where to put those savings.
Retirement workhorses: 401(k)s and IRAs
Most people have two types of accounts available to them:
- Workplace retirement accounts, such as 401(k)s and 403(b)s
- Individual retirement accounts (IRA), including traditional and Roth IRAs
Whether you use one or multiple account types will depend on your work status, what type of plan your workplace offers, your income, and how much you're willing and able to save. So, which accounts, and in what combinations, should you choose?
If you have access to a 401(k) or other employer plan and your employer offers a matching contribution, that's the best place to start. With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping to lower your current income tax bill. Your money—both contributions and earnings—grows tax-deferred until you withdraw it. At that time, withdrawals are taxed at your current tax rate. There may be state taxes as well. (401(k) plans are mostly found in private sector workplaces, while 403(b) plans are usually offered to employees of educational organizations and non-profits. Some rules differ from 401(k) plans, but key points discussed in this article apply to both.)
To understand why you'd want to start with your workplace plan, consider this example: Let's say you make $100,000 per year and your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary (the average employer match is closer to 3%). In this case, at least the first $6,000 of savings you earmark for retirement should go into your 401(k). You don't want to give up the free money your employer is offering as a match.
After you fund your 401(k) enough to get the full company match, you can still set aside more money in a tax-advantaged way—including additional contributions into your 401(k) or contributions to a traditional or Roth IRA—up to annual limits (see table below). For most people, if you have a 401(k) through your employer, it's a good idea to continue to contribute as much as you can afford, or what you calculate you need to reach your retirement savings goals, up to the annual limits.
2021 contribution limits for selected tax-deferred accounts
|Account type||Contribution limit||Additional catch-up contribution for those age 50 and older|
|401(k) and 403(b)||$19,500||$6,500|
|Traditional IRA and Roth IRA*||$6,000||$1,000|
*Contribution limits to a Roth IRA are limited by filing status and adjusted gross income.
One convenience of a 401(k) is that contributions are deducted automatically from each paycheck, making it easy to regularly contribute to your account. You’re less likely to miss money that never shows up in your pocket or bank account in the first place.
Traditional IRA vs. Roth IRA
If you don’t have access to an employer sponsored plan like a 401(k), or if you're already contributing up to the annual limit and want to save more, here are possible next steps:
- If you're eligible to make a deductible contribution to a traditional IRA, consider putting as much as the $6,000 limit there—especially if you expect to be in the same or a lower income tax bracket in retirement when you take withdrawals. (If you're age 50 or older, you can save up to $7,000 in 2021 thanks to catch-up contributions.) Contributions are made on a pre-tax basis, depending on your modified adjusted gross income (MAGI), and you pay no taxes until you withdraw the money.1 If you or your spouse is covered by a workplace retirement savings plan, the tax deductibility of contributions will be subject to income limits.2
- If you're not eligible to make a deductible contribution to a traditional IRA but you're eligible for a Roth IRA, consider putting your $6,000 into a Roth (or $7,000, including a catch-up contribution). Contributions are made with after-tax dollars, meaning there’s no potential tax deduction in the year of the contribution, but qualified withdrawals are tax-free in retirement so long as you've held the account for at least five years and you're over age 59½. You will be eligible to contribute to a Roth IRA only if your income is below certain limits.3
A number of things have to be weighed before deciding if a Roth IRA is your best option. If you expect you might be in a higher tax bracket when you make your withdrawals—current income tax rates are near post-WWII lows and could rise in the future—the Roth may be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes, but a Roth IRA still has other advantages, including no tax on your accumulated investment earnings.
Also, Roth IRAs aren’t subject to annual required minimum distributions (RMDs) starting at age 72 (70½ if you turned 70½ in 2019 or earlier). 401(k) plans and traditional IRAs do have RMDs. That's an advantage if you want your Roth IRA to continue growing tax-free through the later years of your retirement. It could also benefit your heirs, who'd be able take money out income tax-free after you're gone. Note, though, that inherited Roth IRAs may be subject to RMDs for the beneficiary.
Finally, contributing to a Roth IRA is a way to add more flexibility to your tax situation in retirement—having accounts with pre-tax and post-tax funds gives you more options for income and tax planning.
The Roth 401(k)
More and more employers are making a Roth option available in their 401(k) plans. A Roth 401(k) account works much like a Roth IRA, but there is no income limit to prevent participation. However, Roth 401(k)s are subject to RMDs, and note that any matching contributions from your employer must always go in a pre-tax account even if you only have a Roth 401(k).
Eligible employees can contribute up to the 2021 contribution limit of $19,500 per individual after tax (plus a $6,500 catch-up contribution for those 50 or older). Also, the balance from a Roth 401(k) can be rolled over directly into a regular Roth IRA when you leave the employer, thereby circumventing RMD rules.
Assuming your employer offers the option, a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement, or if you want flexibility and diversification in the way distributions from your retirement accounts will be taxed when you reach retirement, as described above. If you're in a lower bracket when you retire, then a traditional 401(k) may end up being the better choice, as you'd pay less tax on future withdrawals than you would pay making post-tax contributions to a Roth 401(k) today.
One way to hedge against uncertainty about future tax rates or your tax situation, or to provide more flexibility to manage taxes in retirement, may be to split your contributions between the traditional option and the Roth option, assuming your employer makes both available.
Having multiple kinds of accounts would allow you to draw from across your taxable, tax-deferred and tax-free accounts in a way that allows you to reduce your tax bill over time. So, instead of drawing from your tax-deferred accounts early in retirement and saving your tax-free accounts for later, you’d withdraw just enough from your taxable and tax-deferred accounts to “fill up” your tax bracket, and then tap tax-free sources for the remainder of your income needs each year.
What if I’ve maxed out my 401(k) and IRA limits?
If you’ve maxed out your 401(k) and IRA options, congratulations. You’re making significant steps to save for retirement.
If you want to save even more, consider a:
Regular brokerage account: Traditional brokerage accounts don’t offer the advantage of tax-free or tax-deferred investment earnings, but they can be relatively tax efficient if managed smartly. Consider putting your least tax-efficient investments (actively managed mutual funds, REITs, and other securities where income is taxed when earned, for example) in your tax-advantaged retirement accounts and more tax-efficient investments (passively managed funds, exchanged-traded funds, municipal bonds and stocks held for more than one year, for example) in taxable brokerage accounts.
Nondeductible contribution to a traditional IRA: Even if you’re covered by an employer plan and you’re above the income limit for a Roth IRA or a deductible contribution to a traditional IRA, you could make a nondeductible (after-tax) contribution to a traditional IRA—but whether you should is a tough call.
You won’t receive an up-front deduction, and any earnings will be taxed as ordinary income when you withdraw them. Alternatively, you could make a contribution to a nondeductible IRA and then turn around and convert that to a Roth IRA. The rules for conversions can be complex, so be sure to speak with the appropriate financial professional before doing a conversion. So, in the end, a regular brokerage account that contains tax-efficient investments may be more efficient.
The advantage of tax-deferral rests primarily on the potential for tax-deferred compounding. But there are also ways you can invest to delay or defer taxes in taxable brokerage accounts by not trading actively and investing tax-efficiently.
The bottom line
If you haven't begun to save for retirement—or you’re saving less than you should—what are you waiting for? Now that you know more about which retirement accounts may make the most sense, it’s time to put your savings plan into action.
1If you withdraw money from a traditional IRA before age 59½, your deductible contributions and earnings (including dividends, interest, and capital gains) will be taxed as ordinary income. You may also be subject to a10% penalty on early withdrawals, and a state tax penalty may also apply. Consult IRS rules before contributing to or withdrawing money from a traditional IRA.
2For those covered by a workplace retirement plan, traditional IRA contributions are deductible if 2021 modified adjusted gross income (MAGI) is below $76,000 (single filers) or $125,000 (joint filers); if income is near those limits, contributions may be only partially deductible.
3For 2021, you are eligible to contribute to a Roth IRA if your MAGI is below $140,000 (single filer) or $208,000 (joint filer); if your income is just below those levels, you may not be eligible to contribute the maximum.