Americans don’t like to think about retirement. According to a recent report by the Federal Reserve, 6 in 10 respondents who aren’t retired yet and have a self-directed retirement plan, such as an individual retirement account (IRA) or a 401(k), don’t feel comfortable making investing decisions.
This discomfort with key retirement decisions can be blamed in part on the fact that many Americans don’t have the right savings strategy for retirement. Let’s take a look at some scenarios of hypothetical savers that could provide you with novel IRA saving strategies.
Picking the right IRA for your retirement savings
401(k) accounts provide millions of Americans with a retirement savings account. Still, not everybody has a 401(k) — and even those who do have one should complement it with an individual retirement account (IRA).
Given you have a limited amount of income at your disposal to sock away for retirement, what kind of IRA would work best for you depends on your individual situation. Here’s a few scenarios for different kinds of savers, providing a combination of accounts that play to the strengths of their financial situations.
IRA retirement saving strategy: Entry-level office worker
What you need to do: You may have to endure endless status meetings and office birthday parties for coworkers you barely know, but at least you have a 401(k) with an employer match. You should set your contribution to maximize your employer’s 401(k) match and open a Roth IRA in order to tax advantage of your biggest asset: your potential future earnings.
Why you need to do it: Employers who match your contributions to your 401(k) are essentially giving you free money. Even if you’re working for a modern day Mr. Scrooge who doesn’t give you a match, a regular 401(k) account still allows you to make contributions directly from your paycheck before any tax is applied, and those contributions will remain safe from the IRS until you begin taking your withdrawals decades later.
As an entry-level office worker, you’re probably not making a lot of money, and that likely puts you in a lower tax bracket. By the time you’re ready to take your withdrawals, you may discover the money you saved by avoiding taxes isn’t worth the bigger bite Uncle Sam takes now that you’re a member of the country club crowd.
To see this in action, take a look at the income tax brackets for tax year 2019. Even if we make a generous assumption regarding your salary as an entry level office worker and say you earn more than $39,475 (but less than $84,200) a year, you still would only be taxed 22% on this income. That means the money you contributed to your 401(k) was sheltered from this 22% tax, and you face tax payments when you withdraw it in retirement, decades later. If you were a retiree taking withdrawals this year and making, for example, more than $160,725 (but less than $204,100) you could be paying up to 32% on money you withdraw from a 401(k).
Contributions to a Roth IRA are not sheltered from taxes, meaning you pay taxes on all your income and then make your Roth contribution, while the interest earned in the Roth is tax-free. Because you’ve already paid income tax on Roth IRA contributions, you aren’t taxed again when you take your withdrawals from the account. Anyone who expects to find themselves in a higher tax bracket when they’re ready to retire should open a Roth IRA now, as you can reap extra tax benefits from your current status as a lowly office drone.
IRA retirement saving strategy: Self-employed freelance worker
What you need to do: Whether you’re making enough money from your Etsy shop to avoid the 9-to-5 office grind or you hop between projects as a freelancer, the freedom of self-employment comes with non-trivial costs. But you don’t have to sacrifice your retirement savings just because you don’t have a 401(k). On the contrary, you need to look into opening a Simplified Employee Pension (SEP) IRA and a Roth IRA.
Why you need to do it: A SEP IRA is a retirement account that’s easy to set up and has low, or often zero administrative fees, which are big advantages for the busy freelancer. It also allows you to contribute up to 25% of the gross annual salary you make from the business (which as a self-employed freelancer usually works out to about 20% of your adjusted net income), up to a limit of $56,000 in 2019. That far outstrips the $6,000 contribution limit on traditional and Roth IRAs for those under 50 years of age, making it a powerful saving tool for your retirement.
However there’s no Roth version of a SEP IRA, meaning all of the contributions you make to it will be taxed when you start making your withdrawals — at whatever tax bracket you happen to find yourself in. That’s why you may also want to open a Roth IRA so you have a source of money you can withdraw tax-free.
IRA retirement saving strategy: Bold market expert with money to burn
What you need to do: When it comes to saving for your retirement, we generally advocate for a slow and steady approach. However, if you don’t have confidence in traditional investment assets such as stocks and bonds but are brimming with self-assurance about your ability to judge non-traditional investments such as real estate, you can open a self-directed IRA.
Why you need to do it: Because you’re convinced you need more flexibility in your investments than a gold medal gymnast, you want a tax-advantaged account for your holdings in peacock farms, marshmallow factories, and yacht fleets. In short, you want to make sure you’ve diversified your investments to such a degree that even if the unthinkable happens and the market permanently implodes you’ll have a safe haven of funds.
If you go down this route, pay attention to the additional pitfalls that come with a self-directed IRA, such as the fact that you won’t have a team of financial experts vetting the quality of your investments and that you can inadvertently disqualify your IRA of its tax advantages if you gain a direct financial benefit from one of the IRAs investments (beyond the money it earns for your IRA).
The bottom line on IRAs
None of the three scenarios outlined above will likely fit your unique financial situation to a T, but it should prove a good starting point for you to think about how an IRA can work into your overall retirement savings strategy. Putting away any money at all is better than nothing, but when it comes to the savings that will fund your golden years, “better than nothing” may not be good enough. Make sure you’re doing everything you can to make sure your IRA is A-OK.