Investing Across Retirement Accounts
For most investors, the next most important goal is to save for retirement. Dedicated retirement accounts such as 401(k)s and IRAs are the clear favorites when investing for retirement, because they offer tax benefits that no other account can match. The major types of retirement plans include the following:
401(k)s and other employer-sponsored accounts. These plans come in two flavors: traditional and Roth. Contributions to traditional plans come out of pretax income. As a result, any money you deposit in the plan will reduce your taxable income for the year in which you make the contribution—lowering your tax bill for that year. What’s more, investment earnings in the account won’t be taxed until you withdraw the money. That tax deferral can help your investments grow much faster than they would in a brokerage account.
Even better, most workplace plans will match your contributions, up to a certain percentage of your salary—for example, a typical plan might contribute 50 cents for every dollar you contribute, up to 6% of your salary. Some generous plans will match 100% of your contributions up to the predetermined level.
You also may be eligible for a Roth version of your employer’s plan, although this new type of account is just starting to catch on. If you go with the Roth plan, your contributions won’t reduce your taxable income for the year in which you make them—but you won’t have to pay any tax on withdrawals in retirement. Essentially, choosing a Roth over a traditional plan means trading an immediate tax break for a future tax break. Contributions to Roth accounts may trigger matching contributions, but the employer match will be deposited in a traditional, tax-deferred plan.
Your investment options in a 401(k) or similar plan are limited to a predetermined menu of funds. (Fidelity Independent Adviser’s quarterly publication, 401(k) Accelerator, can help workers with some of the most common plans select investments.) On the bright side, you can arrange with your employer to have a set percentage of your salary deposited directly from your paycheck into the plan so your saving happens automatically.
Individual Retirement Accounts (IRAs) are self-directed plans that you can set up with a brokerage firm, mutual fund company or other financial institution. They offer at least one significant advantage over workplace plans: You may invest in virtually any publicly traded security. Like 401(k)s, IRAs come in both traditional and Roth varieties.
Like traditional 401(k)s, traditional IRAs offer pretax contributions and tax-deferred growth. However, if you qualify for an employer’s plan, you can’t make tax-deductible contributions to a traditional IRA, unless you fall below certain income limits. Roth IRAs, which are available to any taxpayer with earned income below certain thresholds, offer tax-free investment growth.
Between Roth and traditional 401(k)s and IRAs, you may have multiple options for where to hold retirement savings. The following guide can help most investors make the most of their retirement assets.
Step 1: Contribute enough to your workplace plan to generate the maximum company matching contribution. The prospect of an immediate, guaranteed 50% or 100% return on your investment is far too good to pass up.
You may have to choose between traditional and Roth versions of the plan. In general, Roth plans are better for younger investors, who have more time to benefit from tax-free investment growth. They also may be preferable for relatively wealthy investors who expect to pass on significant sums to future generations, because the heirs won’t have to pay income tax on their withdrawals. Traditional plans may be better for investors who are closer to retirement and expect to be in a lower bracket when they withdraw the money.
Step 2: Invest through a Roth IRA, if you’re eligible to do so. Funding a Roth IRA will give you greater control over your retirement investments than your 401(k) provides, and the Roth’s tax-free growth may provide superior investment growth to that of a traditional plan over long periods. What’s more, a Roth account can help you hedge against the very real possibility that tax rates will rise between now and the time you retire.
You may contribute up to $5,000 to a Roth IRA in 2008 ($6,000 if you’re 50 or older), provided your income is $101,000 or less (singles) or $159,000 or less (married couples). Contribution limits decrease for investors with higher incomes, phasing out completely at $116,000 and $169,000, respectively.
Step 3: Return to your workplace plan. Most 401(k)s allow contributions of up to $15,500 in 2008, as well as an additional $5,000 in catch-up contributions if you’re age 50 or older.
Of course, some workers may not qualify for a workplace retirement plan. If you are self-employed, look into opening a SEP-IRA, which in most cases allows higher contributions than do other types of IRAs. (SEP-IRAs offer pretax contributions and tax-deferred growth, like traditional IRAs and 401(k)s.) If you’re not self-employed, you don’t qualify for an employer’s plan, and you exceed the Roth IRA’s income limits, you might opt for a traditional IRA.
Keep in mind that retirement accounts generally carry severe penalties for withdrawals before you reach age 59 1/2 (although workplace plans may allow you to make withdrawals penalty-free beginning at age 55). So while it’s wise to save as much as possible for retirement, you’ll want to make sure not to contribute money to the plan that you might need before then.
