Saving for retirement can be accomplished in many ways. Your employer can drive the process by encouraging your participation in a company plan, like your 401(k) or the Thrift Savings Plan (TSP). This encouragement typically comes in the form of a contribution match. You can contribute funds to a deductible IRA. And you can make non-deductible contributions to a Roth IRA. If your tax advisor thinks it makes sense for you, you might be able to contribute to all three. There are advantages with each of them. Determining what combination is right for you is a question for you to answer with help from a tax adviser. But here are the ways that each of these may help you save for retirement.
1. Why Your Employer’s Savings Plan is Such a Bargain
The 401(k) is likely the best-known employer sponsored savings plan. If you work for a charity or a public school, your plan would have a different name, but similar features. That’s also true for active duty military and other government workers who contribute to the TSP program.
For each of these groups, the mechanics of their retirement plans are very much alike. The key feature is their quasi-tax deductibility.
Are Savings Plan Contributions Tax Deductible?
Contributions you make to your 401(k), 403(b), or the TSP are made before you receive your paycheck. They are excluded from your taxable income as opposed to deductible from it. All by itself, this is hugely beneficial. Here’s how.
Assume you contribute $2,000 to your 401(k). Also assume your marginal tax rate is 25 percent. Here are the economics of this.
By excluding the contribution from income, you save $500 ($2,000 times 0.25) in taxes. In reality you contribute the whole $2,000, but your net cost is $1,500.
For many people the economics are even better than this. Those in a higher marginal federal tax bracket have bigger tax savings.
Many Employers Match Contributions
The economics of retirement plans like the 401(k) get even better for people whose employers provide some sort of matching contribution. An employer match is a regular and ongoing windfall. As long as you keep saving, the windfall keeps coming. And the economics are huge.
Assume that your employer matches half of your contributions up to a certain percentage of your total salary. Assume too that the $2,000 from the previous example falls within your employer’s cap on matching contributions.
Under these circumstances, your contribution is $2,000. Your employer’s contribution is an additional $1,000. It’s like found money.
Why Tax Deferral Matters
Another reason to contribute to your employer’s retirement saving plan is that the returns you earn can accumulate tax deferred until you withdraw them. You will be taxed on those future distributions, but in the meantime you can avoid paying taxes on any income and growth.
The combination of regular contributions, compounding over time, and funds remaining in the account untaxed is a powerful combination. This combination also exists for investments in an IRA.
2. A Traditional IRA
There are a few differences between a traditional IRA and an employer-sponsored retirement savings plan like a 401(k), 403(b), or TSP. The main difference is as the name implies. It’s an individual retirement account. You are the only person contributing to the plan.
Another difference is that contributions made to an IRA typically are made from dollars you receive after your paycheck is issued to you. As such, taxes have been deducted from the funds you use to contribute to your IRA. But you can claim that contribution as a tax deduction.
To reiterate an earlier point, your contribution to your 401(k) is excluded from your income and your contribution to your IRA is deductible from your income. As a practical matter they receive roughly the same tax treatment. One is no more favorable than the other…except in terms of contribution limits.
There are limits on how much you can contribute to your IRA. For people earning more than a ceiling amount, contributions aren’t deductible at all. For people earning less than the ceiling, and who are over a certain age, there is a catch-up contribution.
Yet in every scenario, the contribution limits of an employer-sponsored retirement savings plan are a multiple of what can be contributed to a traditional IRA.
Still, in the right circumstances, an IRA can be a great way to save for retirement. Investments in an IRA enjoy the same tax deferral as those in an employer sponsored retirement savings plan. Then, when you retire and start withdrawing from your IRA, those distributions are taxed as ordinary income just as they would be from a company plan.
3. The Roth IRA
Another retirement savings opportunity is a Roth IRA.
Contribution limits for a Roth are similar to a traditional IRA. Like a traditional IRA, contributions are made with after-tax dollars. The difference between contributions to a traditional IRA and a Roth IRA is that those made to fund a Roth IRA are never deductible. Still, Roth IRAs have great appeal.
Like other forms of retirement plans, investments can grow and earn income free of any current or future taxes. But there is a difference.
Whereas distributions from other types of plans eventually get taxed as ordinary income, Roth IRA distributions are never taxed. So, there are different financial planning strategies that can be used to optimize a Roth IRA either alone or in combination with other types of retirement plans.
Strategies for Saving for Retirement
An employer’s retirement savings plan, a traditional IRA, and a Roth IRA each offer unique benefits. You can use one or more of them to help optimize your retirement savings within the broader context of a comprehensive financial plan.
Consult your Financial Advisor to establish a plan that meets your needs and helps guide you toward a financially secure retirement.