Retirement Accounts (IRAs, Roth IRAs, 401K) – Part 3. OK really, just tell me what I need to do!
I am proud to present the NEVER SEEN BEFORE “Retirement Account Ultimate Decision Chart,” which should make it very easy for you to decide where to park your retirement funds.
LET’S MAKE THIS REALLY EASY:
Please work your way through the decision chart above first. But to simplify, here is the GENERAL recommendation if you are in your 20s:
- Ask your HR department at work if your employer provides a 401K match. If there is, contribute enough to your 401K to get ALL OF THE FREE MONEY. If you don’t take all of your FREE MONEY, I will hit you in the head with a heavy brick
- After getting your 401K match (skip that step if there’s no match from your company) open a Roth IRA with a mutual fund company like Vanguard or Fidelity. You can contribute up to $5,000 for 2012
- If you still have left over funds you want to save, put them in your 401K. You can contribute up to $17,000 for 2012.
We recommend the Roth IRA over the Traditional IRA as a first choice for young people for several reasons, including:
- Tax diversification: Since it’s hard to predict what your situation will be when you retire, the 401K (which reduces your tax burden now) and the Roth IRA (which reduces tax burden in the future) allow you to take advantage of both
- Tax rates may go up in the future: By paying your taxes now with a Roth, you don’t have to worry about future income tax increases
- You probably aren’t rich yet: you are just starting your career, so your salary (and your tax bracket) are probably not super high
This is pretty much all you need to know, and most people can stop reading here and go on their merry way. However, if you make a lot of money ($110K or more), want to see the numbers on Roth IRA versus Traditional IRA, or are still confused as to what you should do, read on!
LOOKING AT A FEW SCENARIOS COMPARING ROTH IRA TO TRADITIONAL IRA / 401K
The decision chart contains a question: “Do you think your income tax rate is LOWER than what you’ll pay in retirement?” Most people in their 20s will answer “YES” to this question (your income is not high yet, and tax rates are at all-time lows), and therefore should open a Roth IRA account after getting their 401K match.
However, we hear a LOT of questions about people debating the Roth IRA versus Traditional IRA / 401K. Let’s go over a few cases below:
SCENARIO #1: STUDENT / PART-TIME JOB
I am a student and made $10,000 working part time. I am roughly in the 10% marginal income tax bracket (in other words, for my last $5,000 in income I had to pay $500 in Federal and state income tax)*
RECOMMENDATION: Do the Roth IRA, baby – no doubt about it. You will definitely end up with more money in retirement
SCENARIO #2: AVERAGE ENTRY-LEVEL JOB
I am an average corporate peon making low to mid $40,000 salary. Let’s assume this roughly puts me in a 20% marginal tax bracket (for my last $5,000 in income, I had to pay $1,000 in Federal and state income tax)*
RECOMMENDATION: Go with the Roth IRA for the reasons above (tax diversification + lock in today’s rate) – in most scenarios, you will end up ahead. Note that under the chart’s assumptions, if you believe your combined Federal and state income tax rate will be lower than ~16.7% in retirement (in other words, you retire with modest savings and tax rates don’t skyrocket), you can opt for the Traditional IRA.
SCENARIO #3: BANKSTER OR OTHER HIGHLY COMPENSATED JOB
I am a banker or hedge fund guy making $110K+ (the very low end of finance salaries) and living in New York, or I am computer programmer for Google / Facebook living in San Fran. Not only are my income taxes high, I pay very high state / city taxes because I live in Manhattan / San Fran. Therefore, we estimate a marginal income tax rate of 30%*
- RECOMMENDATION if you make under $110,000: YOU COULD GO EITHER WAY, BUT WE LEAN TOWARDS THE ROTH IRA (due to benefit of tax diversification + lock in today’s rate). Traditional IRA only makes sense if you believe that your Federal and state income tax rate will be lower than ~23.1% in retirement (you retire with modest savings and the tax rates don’t skyrocket) – see chart below.
- RECOMMENDATION if you make over $110,000: YOU ARE RICH! YOU COULD GO EITHER WAY, BUT THE NON-ROTH OPTION (TRADITIONAL IRA OR 401K) IS LESS HASSLE. Traditionally, high income earners like you have never been allowed to invest in the IRA – you have to make less than $110,000 a year. Even though there is now a perfectly legal back-door process to allow you to invest in a Roth, we suggest just sticking to the Traditional IRA. You will save $$ on your very high taxes this year (which are probably even higher than the 30% mentioned in the chart). Equally important, going through the trouble of completing all the paperwork / tax forms required to open a Roth IRA is probably not worth your valuable time (or the $50+ you will have to pay your accountant to fill them out!)
So hopefully everything is clear now! If not, leave questions or comments below.
A couple of technical notes:
- We used the * (asterisk) above when discussing the “marginal income tax bracket.” What we mean if this: if you were to put $5,000 in a 401K / Traditional IRA, how much Federal and state income tax (ignore Social Security and Medicare taxes) would you save? If you could save $500 on your Federal and state income taxes, we considered you as part of the “10% marginal tax bracket for Federal and state income tax”
- The “10%, 20%, or 30% tax bill” at retirement assumes all applicable Federal and state income taxes that you have to pay on Retirement Account withdrawals (note you do not have to pay Medicare or Social Security taxes on withdrawal)
- The charts assume tax rates from this handy tax calculator