There are several types of retirement accounts. Which account you should fund depends on your circumstances. However, here are some general guidelines you can follow to make your decision.
First, fund your 401(k) or 403(b) if you have a match. Select the Roth side if available. If not, fund the Traditional.
Many employers sponsor a contribution plan such as a 401(k) or a 403(b). Some also offer a match program whereby the employer matches an employee’s contributions.
An example of this would be for the first 3% of the employee’s salary contributed, the employer matches the contribution and then he matches half of the next 2% as well.
This matching methodology is often called a safe harbor match and is very common.
Contributing 5% of your salary and receiving a match of 4% of your salary is the quickest way of earning an 80% return. For this reason, if your employer offers a match you should prioritize contributing enough to get the full match offered.
Depending on your plan, you may be able to select between a Roth 401(k)/403(b) or a traditional 401(k)/403(b) contribution. However, regardless of where you contribute, your employer match will always be put into a traditional account.
Roth contributions do not receive a tax deduction but avoid all future taxes. Traditional contributions receive a tax deduction but will face taxes when you withdraw the larger appreciated amount in retirement.
A Roth contribution is generally preferable.
Your employer sponsored plan is a great place to begin, but funding your 401(k) or 403(b) with 5% of your salary and receiving a 4% match from your employer is not sufficient to fund your retirement. You should save at least 15% of your salary over your entire working career to be on track for your retirement. And you need to save more if you are late getting started.
Next, fund your Roth IRA.
Contributions to Traditional or Roth IRAs are governed by separate legislation from employer sponsored 401(k)/403(b) plans. In 2015, the limits for contributing to a traditional or Roth IRA are $5,500 plus an additional $1,000 if you are age 50 or over.
For the average individual, contributing to a Roth IRA should be your next priority after getting the match for your 401(k)/403(b).
If you can’t fund your Roth, fund a Backdoor Roth.
In 2015, you are not allowed to make full contributions to your Roth IRA if your Adjusted Gross Income is over $183,000. However, you may still be able to contribute anyway with what is called a backdoor Roth.
Even with a high income, you are still allowed to contribute to a non-deductible IRA. Your contribution is put in after taxes. Then, you are allowed to convert that IRA to a Roth. Assuming that you have no other traditional IRAs, the money you convert will not be taxed because it has already been taxed. But if you have any other IRA money, then the conversion will be taxed at the pro-rata amount which has not been taxed.
401(k) and 403(b) account balances do not affect a backdoor Roth contribution, but other traditional IRA accounts do. A backdoor Roth is appropriate only after you have converted all of your traditional IRAs to Roth accounts. Then you can continue to make the equivalent of Roth contributions through non-deductible IRA contributions and immediate Roth conversions.
For those in the upper incomes, a $5,500 or $6,500 contribution may not seem like it will make a big difference, but it will. When you add up even one individual’s contributions and growth across a decade, it can easily amount to over a million dollars protected from taxes in a Roth account. If husband and wife both make contributions, that amount could be doubled.
Then, fund your Roth 401(k) or 403(b) more.
After getting the maximum match offered by your employer, you can still contribute more to your 401(k). For 2015, your contribution is limited to $18,000 plus a $6,000 catch-up provision if you are 50 or older. Roth contributions are still usually preferable.
Next, contribute to your SEP IRA.
A SEP IRA stands for Simplified Employee Pension Plan (SEP) IRA. If you have self-employed income you can contribute to a SEP IRA in addition to your employer’s 401(k) or 403(b).
SEP contribution limits for 2015 are the lesser of 25% of the employee’s income or $53,000. There are no catch-up provisions. This contribution can be in addition to what you contribute to your 401(k) or 403(b) through your employer.
While 401(k) or 403(b) contributions are considered employee contributions limited on a per person basis, SEP contributions are considered employer contributions which are limited on a per plan basis not a per person basis.
If you are already maxing your employer-sponsored plan, this is a way to shelter up to $53,000 more for each separate business entity. If you are contributing 25% of your income, self-employment taxes will bring the actual percentage down to about 18.6%.
SEP IRAs can also be used when a business has more than one employee. Since the same percentage is given to all employees, this vehicle especially works well for married couples who are working together at their family business. Each year, you are able to set a different percentage for employer contributions between 0% and 25%.
A SEP IRA is also a good vehicle for professors who consult or lecture, doctors who engage in expert testimony, or other professionals who have incorporated a portion of their work. They are probably already highly compensated and putting money into a SEP allows them to reduce their taxable income this year in the hopes that they will be able to take that income out when they are in a lower tax bracket.
Take a minute to consider a traditional IRA or 401(k)/403(b).
There are cases where funding a traditional IRA or 401(k)/403(b) is preferable to funding a Roth. They are rare, but you should consider if you have one.
Funding a traditional account during years of high income right before years of low income when you can convert it back to Roth can smooth your income and produce tax savings.
Also, moving income from your peak earning years to the gap years or retirement may move income from higher tax brackets to lower tax brackets.
However, be careful not to underestimate the size of your required minimum distributions. The assets in your Traditional may grow too much and actually incur you more tax then you saved.
Lastly, save in your brokerage account.
After all the best tax planning and retirement funding, saving money in a taxable investment account is always a good default. Taxable savings can be used for retirement or tax planning. It can be used to fund living expenses during the gap years and for paying taxes on Roth conversions.
Furthermore, it can be used to supplement your lifestyle while you are maximizing contributions to your retirement accounts with your income.
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