Saving for Retirement: IRA vs. 401(k)  

Retirement was simpler when all you had to do was put in your time at work, retire and collect your check. Between the company pension and Social Security, most retirees figured they had it made. And if they'd managed to save a little extra, it was gravy.

These days, all that's changed. Traditional defined benefit pension plans have become a thing of the past for most workers. And few people seriously expect Social Security to provide the majority of what they hope to spend in retirement.

In short, our ability to save and invest on our own will likely determine whether we realize the retirement of our dreams--or just hope to get by somehow when we're no longer able to work for a living.

Getting started Recognizing the need to save for retirement is the first step. That's followed by prudent retirement planning, which includes figuring out when you'd like to retire, how much you'd like to spend in retirement, and how much you need to save and invest now to get there.

After all that, you might think your next step would simply be to start saving. But with all the different retirement accounts out there--401(k), 403(b) or 457 plans at work, traditional IRAs, Roth IRAs, regular brokerage accounts, deferred annuities--it can be hard to know which are best for you, and in what combination.

Retirement workhorses: IRAs and 401(k)s Your main workhorses for retirement savings will likely be an IRA along with a 401(k), 403(b), 457 or other qualified employer plan, depending on what your workplace offers.

If you have earned income but your employer doesn't offer a retirement plan, you can always start by putting money in a traditional IRA or Roth IRA. But if you also have access to a 401(k) or other employer plan, should you fund your 401(k), your IRA, or both?

The best choice is to fund your tax-advantage options to the fullest (as shown in the table) if you're eligible, then move on to other ways to save for retirement if you're able (more below). But what if you can't afford to save that much?

Annual contribution limits

401(k), 403(b), 457 or other qualified employer plan Contribution 50 or older catch-up 2005 $14,000 $4,000 2006 $15,000 $5,000

Traditional IRA and Roth IRA Contribution 50 or older catch-up 2005 $4,000 $500 2006 $4,000 $1,000 2007 $4,000 $1,000 2008 $5,000 $1,000

Got a match? If your 401(k) offers a matching contribution, that's usually the best place to start. For example, let's say you make $50,000. Your employer matches your 401(k) contributions dollar-for-dollar up to 6% of your salary, which for you amounts to $3,000. In this case, the first $3,000 of savings should go into your 401(k) plan. Why give up free money?

If you're able to save more than your employer will match, should you put the rest into your 401(k)? Or should you consider a traditional IRA or Roth IRA?

IRA vs. Roth IRA Money you put in a traditional IRA is generally tax deductible no matter how high your adjusted gross income (AGI) might be--unless you're an active participant in a qualified employer plan such as a 401(k), 403(b) or 457.

In that case, a traditional IRA contribution for 2005 is fully deductible for single filers with an AGI of $50,000 or below (partially deductible between $50,000-$60,000). For married filing jointly, the phase-out range for deductibility is between $70,000-$80,000 ($150,000 limit for the non-participant spouse of an active participant in a qualified employer plan, when filing jointly).

Contributions to a Roth IRA are never tax deductible, but qualified withdrawals are tax-free (unlike withdrawals from traditional IRAs, which are taxed as ordinary income). For 2005, you can contribute the maximum $4,000 to a Roth IRA if your AGI is below $95,000 for single filers and $150,000 for married filing jointly. You can make a partial contribution if your AGI is between $95,000-$110,000 for singles and $150,000-$160,000 for married filing jointly.

If you're still able to save more after taking advantage of your employer's 401(k) match limit, here's what you should do next:

If you're eligible to make a deductible contribution to a traditional IRA, consider putting your next $4,000 there--especially if you expect to be in the same or lower income tax bracket in retirement when you take withdrawals. You're still getting a pre-tax deduction as you do with your 401(k), but you'll likely have more investment choices. If you can afford to save more after contributing $4,000 to a traditional IRA ($4,500 if you're 50 or older in 2005), then continue with your 401(k) up to the maximum allowed.

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 next $4,000 into a Roth ($4,500 if you're 50 or older in 2005). Your contribution won't be deductible, but qualified withdrawals will be tax free down the road. If you're in a higher tax bracket when you make your withdrawals, the Roth would be especially attractive. Ending up in the same bracket would mean a wash for income tax purposes--but a Roth IRA has other advantages.

A Roth IRA doesn't force you to take required minimum distributions at age 70½, as you'd have to do with a qualified employer plan or traditional IRA. That's an advantage in terms of letting your Roth IRA continue to grow tax deferred in your later years. It could also benefit your heirs, who'd be able take money out income tax free after you're gone.

Again, if you're able to save more after you put $4,000 in a Roth, continue with your 401(k) until you max it out.

If you're eligible for neither a deductible contribution to a traditional IRA nor a Roth IRA contribution, then just continue with your 401(k) until you've contributed the maximum allowed. Coming in 2006: The Roth 401(k) In January 2006, the "Roth 401(k)" account (403[b] plans will also be eligible) goes into effect. It would work much like a regular Roth--contributions would come from after-tax dollars and qualified withdrawals would be income tax- free. But there would be no income limit to participate!

Employees could contribute to either the traditional 401(k) or the Roth 401(k), up to the 2006 contribution limit of $15,000 per individual, plus an additional $5,000 catch-up contribution for those 50 or older. Also, the balance from a Roth 401(k) could be rolled over directly into a regular Roth IRA when you leave the employer. An employer match, if any, would automatically go into the traditional 401(k) option, regardless of where the employee contributions are directed.

The choice of a Roth 401(k) could make sense if you think your tax bracket will be the same or higher in retirement--not a bad guess given today's relatively low tax brackets and the potential to generate significant portfolio income and retirement distributions from other deferred accounts. If that's the case, then maxing out on a Roth 401(k) and then contributing to a Roth IRA, if eligible, might be the way to go. On the other hand, if you're in a lower bracket when you retire (or, even worse for the Roth, if the current income tax is replaced by a flat tax or consumption tax), then a traditional 401(k) would have been a better bet. One way to "hedge" against the unknown is to split your contributions between the traditional option and the Roth option, assuming your employer makes both available.

One obstacle to the new Roth 401(k) is the temporary nature of the 2001 Tax Act, most of which expires after 2010, including the Roth 401(k). So, companies may be reluctant to implement an employee benefit that might only last five years. According to Hewitt Associates, about 35% of 200 top companies surveyed may add the Roth 401(k). Check with your employer.

Example using 2005 limits Your salary is $90,000. Your goal is to save 20%, or $18,000. Your employer matches your 401(k) contributions, up to the first 6% of your salary ($5,400).

First $5,400 to 401(k) Next $4,000 to a Roth IRA (not eligible for a deductible contribution to a traditional IRA) Next $8,600 to 401(k) In this case, you're able to contribute the full $14,000 limit to your 401(k) and the full $4,000 limit to a Roth IRA.

If the amount you're able to contribute to an IRA and 401(k) each year is less than the maximum allowed, you would follow the order above until you reached your personal savings limit (assuming the employer match).

Keep in mind your 401(k) has a distinct advantage: Once you set your savings percentage, you're on "pay yourself first" autopilot. Since you have a greater opportunity to spend money earmarked for your IRA, you need to be more disciplined about saving it.

What if I've maxed out my 401(k) and IRA? If you've maxed out your 401(k) and whatever IRA option makes the most sense, and you're looking to save more, kudos are in order!

Here's where to go with those extra retirement dollars:

Regular brokerage account. Additional retirement savings can go right into your brokerage account. Remember, even if you hold retirement assets in both taxable and tax-advantaged accounts, you should consider all your investments as one big portfolio reflecting a single asset allocation. What's more, you may be able to add value by placing more tax-efficient investments in your taxable accounts and less tax-efficient investments in your tax-advantaged accounts (for more, see Tax-Efficient Investing Is More Important Than Ever).

Non-deductible contribution to a traditional IRA. Even if you're covered by an employer plan and you're above the AGI limit for a Roth IRA or a deductible contribution to a traditional IRA, you can still make a non-deductible contribution to a traditional IRA. Whether you should or not is a tough call. Besides no up-front deduction, any earnings will be taxed as ordinary income when you withdraw them, so a non-deductible IRA contribution isn't an overly compelling choice. The advantage rests solely on the benefit of tax-deferred compounding. But you could effectively defer taxes on stocks in your taxable accounts by trading infrequently or buying an index fund. And if you're in a higher tax bracket and you want to hold bonds in your taxable account, you could always buy municipal bonds, which are tax free.

Deferred variable annuities. This option has some similarities to a non-deductible IRA contribution, with some notable differences: Most deferred variable annuities have an optional death benefit, so your heirs would at least be sure to get what you put in, even if your investments lose value. There are no required minimum distributions to deal with. You have the option to annuitize your balance, which might come in handy if you're looking for a regular monthly check at some point during retirement. The downside here is that variable annuities typically include additional costs and fees that can make them relatively expensive. 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 which retirement accounts make the most sense, start filling them up!

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About the Author

Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Investment Research® September 21, 2005