If you’re confused by all the tax-advantaged retirement account options you can choose from, you’re not alone. While it’s great to have more choices than fewer, it can certainly cause analysis paralysis.
Instead of getting caught in a fog of retirement confusion, it’s time to get clarity. Using one or more retirement accounts to sock away savings on a regular basis is the best way to build wealth for the future.
In this post, you’ll learn three simple steps to choose the right accounts for your situation. Plus, I’ll answer a couple of questions on this topic that I recently received from podcast listeners.
3 Simple Steps to Choose the Right Retirement Accounts
- Know the retirement account restrictions.
- Choose your retirement plans.
- Choose your retirement tax types.
Let's explore these steps in more detail.
Step #1: Know the retirement account restrictions.
If you understand a couple of restrictions that the IRS imposes on retirement accounts, you can easily use the process of elimination to select accounts. The only restrictions you need to keep in mind are 1) an income limit for the Roth IRA (Individual Retirement Arrangement) and 2) a deduction limit for the traditional IRA.
What’s the Roth IRA Income Limit?
The Roth IRA is the only retirement account that factors in annual income for eligibility. You’re prohibited from making contributions when your income exceeds certain amounts for your tax filing status.
The Roth IRA is the only retirement account that factors in annual income for eligibility. You’re prohibited from making contributions when your income exceeds certain amounts for your tax filing status.
For 2018, if you file taxes as a single and your modified adjusted gross income (MAGI) is higher than $135,000, you cannot contribute to a Roth IRA. And when you earn from $120,000 to $135,000, you’re in a phase out range, which reduces the amount you can contribute.
If you’re married and file taxes jointly, you cannot contribute to a Roth IRA when your household’s joint MAGI exceeds $199,000. And when you earn anywhere between $189,000 to $199,999, your contribution is reduced.
In other words, when you earn below the phase out ranges for your tax filing status ($120,000 for singles and $189,000 for when you’re married filing jointly), you can max out a Roth IRA. For 2018, you can contribute up to $5,500, or $6,500 if you’re over age 50, if you have at least that amount of earned income for the year.
If your income is in a phase out range, you might be allowed to contribute $4,000 instead of $5,500, for example. To calculate your allowable contribution, there’s a worksheet in IRS Publication 590-A.
But what happens if you open a Roth IRA but have income that rises above the allowable threshold? There’s no downside. You can keep the account, enjoy its tax-free growth, and manage your investments any way you like. You just can’t make any new contributions to a Roth IRA when your income exceeds the annual allowable limit.
Please note that this income limit doesn’t apply to Roth accounts you may be offered at work, such as a Roth 401k or a Roth 403b. You can always contribute to a workplace Roth, no matter how much you earn.
What’s the Traditional IRA Deduction Limit?
Now, let’s cover the second restriction that I mentioned, which is a deduction limit on the traditional IRA.
A major advantage of traditional retirement accounts is getting a tax deduction for contributions. For example, if you earn $50,000 doing freelance work and max out a traditional IRA by contributing $5,500, your taxable income for the year would be reduced to $45,500. The lower your taxable income, the less tax you pay.
But when you or a spouse are covered by a retirement plan at work, your allowable deduction for contributions to a traditional IRA may be reduced or eliminated, depending on how much you or your spouse earn.
When you or a spouse are covered by a retirement plan at work, your allowable deduction for contributions to a traditional IRA may be reduced or eliminated, depending on how much you or your spouse earn.
For 2018, if you file taxes as a single and your MAGI is higher than $73,000, you can contribute to a traditional IRA, but you can’t deduct contributions on your taxes when you also have a workplace retirement plan. And when you earn anywhere between $63,000 to $73,000, you’re in a phase out range, which reduces the amount you can deduct.
If you’re married and file taxes jointly with MAGI more than $121,000, you can’t deduct traditional IRA contributions when you have a workplace plan. And when you earn anywhere between $101,000 to $121,000, the deduction is reduced.
To make this restriction a bit more complicated, if you’re married and don’t have a retirement account at work, but your spouse does, there are also deduction limits. In this situation, if you live with your spouse or file a joint tax return, you can’t deduct traditional IRA contributions if your household MAGI exceeds $199,000. And the phase out range is from $189,000 to $199,000.
Again, this deduction limit doesn’t prevent you from being eligible for a traditional IRA. You can always max one out, but the tax deduction you receive may be reduced or eliminated.
You may be wondering if it’s worth it to make non-deductible contributions to a traditional IRA. They’re not as good as deductible contributions, but you may not have another option if you’re a higher earner.
The good news is that non-deductible contributions to a traditional IRA still grow tax-deferred until you take withdrawals in retirement, giving you substantial tax savings over time.
Step #2: Choose your retirement plans.
Now that you understand that high earners have income and deduction limits, you can use this information to choose retirement plans. Here’s a summary of the three main types of retirement plans:
- Employer-sponsored. Can be used when offered by your employer. Examples include a 401k, 403b, or a 457 plan.
- Self-employed. Can be used by any individual with some amount of self-employment income. Examples include a SEP-IRA, solo 401k, or a SIMPLE IRA.
- Individual. Can be used by any individual (including minors) with some amount of earned income, or by a spouse with no income who files taxes jointly. The only two options are a traditional IRA and a Roth IRA.
You can even have multiple retirement plans as long as you don’t exceed their annual contribution limits. For instance, if you have a job with a 401k and income from a side business, you can contribute to an IRA, a 401k, and a SEP-IRA in the same year.
Rules for Employer-Sponsored Retirement Plans
If you’re fortunate enough to have a retirement account at work, that’s the first plan you should choose. Not only do they come with high contribution limits and broad federal legal protections, but many employers offer free matching funds just to reward you for participating.
If you’re fortunate enough to have a retirement account at work, that’s the first plan you should choose. Not only do they come with high contribution limits and broad federal legal protections, but many employers offer free matching funds just to reward you for participating.
For 2018, you can contribute up to $18,500, or $24,500 if you’re over age 50, to most types of employer-sponsored retirement plans. If your employer pays matching funds, you can exceed the annual limits.
Rules for Self-Employed Retirement Plans
If you don’t have a workplace retirement plan, but are self-employed, a SEP-IRA is a good choice if you have employees or plan to someday. And if you’re a solopreneur with no employees, a solo 401k is a great option.
For 2018, you can make SEP-IRA contributions for each of your employees (including yourself) up to 25% of each employee’s compensation for a maximum of $55,000. If you have a 401k or 403b with another employer, the total you can contribute to both plans is limited to 100% of your compensation, up to $55,000.
With a solo 401k, you can contribute up to 25% of your net earnings up to $55,000, or $61,000 if you’re over age 50. If you also participate in a 401k at another company, the total employee contribution you can make to both plans is $18,500 or $24,500 if you’re over 50.
See also: 5 Steps to Create Your Own Self-Employed Benefits Package
Rules for Individual Retirement Plans
If you’re a worker who doesn’t have a retirement plan at work, your go-to option is an IRA. As I mentioned, just about everyone is qualified to have one and you can combine them with other types of retirement plans.
However, IRA contribution limits are relatively low. As I previously mentioned, for 2018, you can contribute up to $5,500, or $6,500 if you’re over age 50. So, maxing out an employer-sponsored plan or a self-employed plan first makes sense, when possible.
I received a related question from Bill L. who says, “Love the podcast. What options do temporary or part-time employees have to cut taxes and save for retirement when they don’t qualify for a workplace plan that’s only offered to full-time employees?”
Thanks for your note, Bill. Many people work for small businesses that don’t offer a retirement plan or that require you to be a full-timer to qualify. Unfortunately, administering a retirement plan is costly for companies, so consider yourself lucky if you do have one at work.
The solution for anyone who doesn’t have a retirement plan at work is to open an IRA. And if you work for yourself, you can also choose retirement plans just for the self-employed.
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Step #3: Choose your retirement tax types.
After choosing one or more types of retirement plans to fund, a key decision will be which tax type to choose: traditional, Roth, or both. Most retirement accounts come with a Roth option and you can split contributions to both types, as long as you don’t exceed the annual contribution limit.
Most retirement accounts come with a Roth option and you can split contributions to both types, as long as you don’t exceed the annual contribution limit.
For example, if you’re qualified for a Roth IRA and are under age 50, you could contribute $2,000 to a traditional IRA and $3,500 to a Roth IRA in the same year—but not $5,500 to both.
The same concept applies when you have a workplace plan with a Roth option. You could contribute $10,000 to a traditional 401k and $8,500 to a Roth 401k in the same year—but not $18,500 to both.
So, how do you know if a traditional, Roth, or a combination of tax types is right for you? Well, start by answering these three questions:
1. Is my income tax rate going to be higher or lower in retirement?
With any traditional retirement plan, you get a break by delaying taxes until you take withdrawals in retirement. You end up paying tax on your original contributions and their investment growth.
Roth accounts work the exact opposite way. With a Roth, you pay tax upfront on contributions, and then pay zero tax on withdrawals in retirement. You skip paying tax on all the investment earnings, which can be a massive savings.
To pay as little tax as possible, consider if your income tax rate could be lower now relative to when you retire. If you believe that you’ll be in the same or a higher tax bracket in retirement, choosing a Roth is best.
The idea is that paying tax on Roth contributions upfront at a lower rate saves you money. Here are some situations where your tax rate could be higher in retirement than it is today:
- You’re currently in an entry-level job and expect to be earning more in the future.
- You expect to receive an inheritance in the future.
- You have a hunch that income tax rates for all Americans will rise in the future.
But if you’re further along in your career and earn more now than you believe you will in retirement, you’re generally better off with a traditional IRA or traditional plan at work. When you take withdrawals in retirement, you’ll end up paying less tax if you have a lower tax rate than you do today.
Problem is, none of us really know what will happen in the future, especially if you’ve got a long way to go until retirement. So, if you’re not sure about your tax rates, another tip is to diversify by having both traditional and Roth accounts. That way you’ll have taxable and non-taxable money to spend in retirement.
For instance, you could put half your contributions in a traditional 401k and half in a Roth 401k. Or you might have a Roth retirement plan at work and a traditional IRA on your own.
See also: Which Is Best: A Roth or Traditional Retirement Account?
2. When do I prefer to pay income tax?
While most people would prefer to never pay taxes, when it comes to your retirement nest egg, at least you have control over when you pay them.
If you have a heavy tax burden from high earned or investment income, making contributions to a traditional retirement account is a smart way to reduce what you owe. You’ll get a tax deduction in the year you make traditional retirement contributions, which cuts your current tax bill.
If you have a heavy tax burden from high earned or investment income, making contributions to a traditional retirement account is a smart way to reduce what you owe.
Roth contributions are never tax deductible, so they don’t help your current tax situation. But, as I mentioned, the beauty of a Roth is that withdrawals in retirement are completely tax free. If your account mushrooms in value over many years, you get to keep every penny in retirement.
So, your current and future tax situation plays a big role in whether you should use a traditional or Roth retirement account. But don’t get too bogged down in the decision. You can always start or stop contributions at any time if your financial situation changes.
3. Do I want penalty-free access to the account before retirement?
Tapping a retirement account before you reach the official retirement age of 59½ typically comes with having to pay income tax, plus a 10% early withdrawal penalty. While you might think it’s unfair to have your wrist slapped, financially speaking, to access your own money, the purpose is to make sure you have funds to spend in retirement, not before!
However, there are some exceptions. Roth accounts offer more flexibility than traditional ones when it comes to taking early withdrawals. That’s because you must pay tax upfront and you control the account as an individual. A Roth IRA allows you to withdraw your original contributions (but not their earnings) at any time and for any reason.
While I recommend leaving retirement accounts untouched until you retire, having a Roth IRA does give you the most flexibility to tap your funds ahead of retirement. So, if you’ve got a long way to go and are worried that you might need to spend some of your retirement savings, choose a Roth IRA, if you’re eligible.
I received a question from Kathryn M. who’s got a retirement account dilemma. She says, “I contribute $18,000 per year to a traditional retirement plan at work, but we also have a Roth option. I don’t have an IRA, but I’m leaning toward choosing a Roth IRA since I already have a traditional account at work. But my boyfriend and I expect to get married in a couple of years and our joint income will likely be too high to qualify for a Roth IRA. So, should I open a traditional IRA instead and change my contributions at work to the Roth option?”
Thanks for your note Kathryn and congratulations on doing such a great job earning and saving! I’m a big fan of using a Roth at work because they don’t come with income limits and allow you to make relatively high annual contributions. So, unless you really need the tax deduction of a traditional plan, switching over to the Roth at work makes sense.
Again, unless you need the tax deduction of a traditional IRA, I’d open a Roth IRA while you’re eligible. And if your joint income makes you ineligible down the road, you can simply let it ride and contribute to a traditional IRA instead.
We’ve covered some of the biggest considerations for choosing retirement accounts, but there’s no right or wrong answer. If you’re still not sure, having a combination of tax-deferred and tax-free accounts covers all the bases.
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