Updated: Sep 6, 2019
Saving for retirement is something a lot of people wonder about. Am I saving enough? Am I investing correctly? This worry often prevents people from even starting to save for retirement, making them miss out on some valuable years of investing. When it comes to saving for retirement, the earlier you start, the bigger nest egg you’ll have, so start today! That’s the secret - start saving for retirement now, not tomorrow. But how do you start? If you’re having trouble getting started with retirement investing, below I review a couple scenarios and how I would start investing if I found myself in that situation. However, since the laws regarding retirement plans and taxation of retirement plans changes regularly, talk to a financial adviser and tax professional for expert advice and if you have any questions.
In Everything You Need to Know About Retirement Savings Accounts, I summarize the most common retirement savings accounts. If you need a review, check out that article first. Now that you are familiar with your options, here are my suggestions for how to start investing, based on your own situation, to retire with the largest nest egg possible. However, talk to a tax professional or financial adviser before making your decisions, as everyone’s situation is different, especially if you itemize deductions at tax time.
Your employer offers a Roth 401(k) with or without a match.
Since a Roth 401(k) is like a Roth IRA but with higher contribution limits, you can invest to your heart’s delight (up to $19,000 per year). Even better if your employer offers a match. You should also consider opening Roth IRA, so that you can rollover your 401(k) if you ever leave the company to switch jobs or retire. Note that if your employer offers the option of both a Roth 401(k) and a traditional 401(k), I recommend choosing the Roth 401(k), based on the example at the end of this article. Talk to your Human Resources department to get started.
Your employer only offers a traditional 401(k) with a match.
Unfortunately, a Roth 401(k) is not offered by your employer. However, since they match your contributions, you want to contribute enough of your paycheck to the traditional 401(k) to max out the employer contribution - don't leave that free money on the table. After maxing out the employer match, invest in a Roth IRA that you've opened for yourself and your spouse (if you're married). If you max those out too, then you can keep investing in the traditional 401(k) through work, up to the limit of $19,000. Talk to your Human Resources department to get started.
Your employer only offers a traditional 401(k) without a match.
Since there's no free money to be found through the employer match and a Roth option is not available, you will likely want to start investing in you and your spouse's Roth IRAs in order to maximize your nest egg. If you max these out, then you can start contributing to the traditional 401(k) through work until the limit of $19,000.
Your employer does not offer a 401(k).
If you don't have a retirement plan through work, you should still invest and choose to do so in a Roth IRA. If you max out both you and your spouse's IRAs and want to keep investing, you’ll have to invest in taxable accounts since there are no other tax-deferred retirement accounts available for you to take advantage of. Alternatively, you can also check out whole life insurance policies. Talk to a financial advisor to determine which option is best for you.
You are self-employed.
You can choose to invest in either a Roth IRA or Simplified Employee Pension (SEP) IRA. The account you choose will likely depend on the structure of your business and the number of employees you have, since that impacts your tax liability. So talk to a tax professional or financial adviser to decide which is best for your scenario.
You work for the government.
Many government agencies have special retirement accounts that you can take advantage of beyond the 401(k) and IRA, such as the Federal Employees' Retirement System (FERS), the 403(b) for those who work for public schools, and the 457(b) plan for those in state and local governments. Talk to your Human Resources department to learn more about these and to start investing.
You are a homemaker.
If your spouse earns taxable income and you file taxes jointly, open a Roth IRA for yourself, since your spouse can contribute to your account on your behalf using their earnings.
Why choose Roth over Traditional?
Like I hinted at above, you may be wondering why the Roth 401(k) and Roth IRA seem to be preferred over the traditional 401(k) and traditional IRA. While the traditional retirement account allows you to invest pre-tax earned income, saving yourself money on taxes for the year you contribute, you’ll be paying taxes on a lot more money (due to growth) at possibly a higher tax rate in retirement when the money is withdrawn. With the new tax law passed in 2018, a married couple making less than $100,000 annually (or $62,700 if you’re single) falls in the 10-12% tax bracket. Your tax rate really has nowhere to go but up when you reach retirement. Therefore, if you make less than this amount annually, it makes more sense to invest in a Roth IRA. You will end up with a much larger nest egg thanks to the power of compound interest.
Here’s an example. Say you and your spouse make a combined $100,000 in a year and plan to file your taxes jointly and take the standard deduction. After the standard deduction, you have an adjusted gross income (AGI) of $76,000. Say you invest $12,000 into your IRA. If it’s a traditional IRA or 401(k), your AGI becomes $64,000, which equates to a tax of $7292. If it’s a Roth account, your AGI remains unchanged at $76,000, which equates to a tax of $8732, a difference of $1440. Let’s say you also invest the $1440 tax savings into a traditional 401(k) as well, so your Roth IRA balance is $12,000 and traditional IRA plus 401(k) balance is $13,440 for that year.
If these retirement accounts grow for 35 years at a rate of 6%, then the Roth IRA will contain $92,233, while the traditional accounts have $103,301 - hefty sums for only a year of investing 35 years ago! Now, you decide to take a distribution and withdraw the whole amount, in order to maintain the same income level as you had before retirement. If it’s in a Roth account, you get to keep all of it, since no taxes are due when the money is withdrawn. If it’s in a traditional account, you have to pay taxes on the whole amount. Since tax rates are currently at their lowest level in recent history, you will likely owe a higher rate in 35 years, so we’ll use the 2017 tax bracket and standard deduction as an estimate. With that in mind, you would end up owing $14,303 in taxes on the money withdrawn from the traditional account, leaving you with $88,998. Therefore, although you paid an extra $1440 in taxes in 2019 by contributing to a Roth instead of a traditional retirement account, you end up saving $14,303 in taxes and come out $3235 ahead in retirement for each given year. Multiply that over 35 years, and that’s an extra $113,225 in wealth for your nest egg!! So it's almost a no-brainer to choose a Roth over a traditional 401(k) or IRA if you make less than $100,000 in year (which a large majority of people do!)
Hopefully this summary gives you the confidence to start investing for retirement. Do it today, since the sooner you invest, the longer you give your money to grow and build a nest egg that will make you a millionaire, allowing you and your spouse to retire comfortably and give generously!
If you are interested in learning more, I highly suggest The Millionaire Next Door: The Surprising Secrets of America's Wealthy, available on Amazon!