The following post was originally published on Wealthminder
Figuring out which retirement plan is right for you can be a daunting task. By following the 8 steps below, you’ll be well on your way towards making a smart decision.
1. Determine how much you will save
The first thing you need to do is figure out how much you will save each year for retirement, and there’s no single “right” answer to that question. It depends on a host of personal factors such as age, desired retirement lifestyle, life expectancy, willingness to take risk, expected increases in future income and much more. To get a rough approximation of your answer, you can use any of the numerous retirement calculators on the web. For an even rougher approximation, 10-15% of your current salary is a reasonable starting point. However, in a couple of weeks, you can use our free retirement planner to get a more accurate answer.
The reason it’s important to know how much you plan to save is because different plans have different maximum contribution limits. So, if you want to save more than the maximum allowed by your first choice plan, you will have to pick a second or maybe even third choice.
2. Figure out your options
Who you work for and your current gross income are the 2 most important factors in determining the plans you are eligible to contribute to. For a good overview of the different types of plan and for help in figuring out which one(s) you qualify for, check out “Demystifying Retirement Plans (401k, IRA and more)”. Common options include: 401k, IRA, SEP, SIMPLE, Roth IRA, 457, 403(b) and TSP.
The most likely outcome from this exercise is you will have 2 to 3 options: an employer sponsored plan, an IRA and possibly a Roth IRA.
3. Is a match available
Assuming you have an employer sponsored plan, you should check to see if your employer offers a match. While the rules will vary from employer to employer, the idea is your employer will match a part or all of your contribution (usually with a cap). If your employer does offer a match, in all likelihood this should be your first option, and you should contribute at least enough to get the entire match. It’s free money, and you should take it.
4. What will your future taxes look like
Assuming you still have money to invest after getting your employer match, the choices get a little trickier. If you don’t qualify for a Roth IRA or a deductible traditional IRA, things become simple again You would simply continue to fund your employer plan up to the max contribution limit. However, if you do qualify for both IRA options, you need to take other factors into account to make the best decision, and future tax rates are an important consideration. If you believe your tax rate in retirement will be the same or higher than your current rate, you are likely better off investing in a Roth IRA (or Roth 401k). If you believe your taxes will be lower in retirement than they are now, you are probably better off in either the traditional IRA or your employer’s plan.
5. Will you invest your tax savings?
One factor that will significantly influence whether a Roth or non-Roth plan yields more money at the end of the day is what you choose to do with the taxes you save if you invest in a non-Roth plan. If you choose to invest those savings rather than spend them, the non-Roth plans become a lot more competitive with the returns of a Roth plan. To give a simple example, let’s assume you are saving $5,000 and pay 30% in taxes. If you invest in a pre-tax (non-Roth) plan, you will save $1,500 on your taxes in the year you make the contribution. If you chose to invest those savings, meaning your savings that year are $5,000 + $1,500 = $6,500 versus the $5,000 you would have saved in a Roth, your projected after tax wealth at the end of the day will be much more comparable than if you simply invest $5,000 in both cases.
6. Know your plan’s costs
Another factor to consider is costs. Most employer sponsored plans have significantly higher fees than you can get if you invest on your own using an IRA or Roth IRA. On the other hand, if you aren’t comfortable investing on your own, you may give those savings right back (and more) in advisor fees.
For employer sponsored plans, they are now required to give you documentation on all the costs (including the hidden administrative ones), so you should be able to get this information from your HR department. For self-directed plans, you can get the costs to maintain the account and potential trading costs from your brokerage firm. For most people, you should be able to find a fee-free plan that offers a wide variety of funds and ETFs commission free.
7. Are you disciplined?
One advantage of employer sponsored plans is that they work through payroll tax deductions. For individuals who aren’t as disciplined, this forced savings can be very helpful.
8. Evaluate your investment choices
An advantage most IRAs have over most employer sponsored plans is you aren’t limited to the small number of investment choices your employer has chosen for you. You should look at the options in your employer plan to see how diversified they are and how well they have performed over time.
Your HR department can give you details on the historical performance of the funds in your plan. You should compare them over a full-market cycle (5 years or more) against investing in an appropriate comparable benchmark. What does this mean? Say your plan has a small cap value fund you are interested in. Look at how it’s performance compares against a small cap value index, like the Russell 2000 Value Index.
Putting it all together
Once you have all of this information gathered, you are ready to make a decision. To illustrate how, we will use an example. John is a 42 year old sales executive who makes $130,000 per year. He plans to save $19,500 (15% of his salary) for retirement. He works for a tech company and has access to a 401k plan at work. They match 50% of his contributions up to a maximum of 3%. Based on his income level and the fact that he has an employer plan, he is eligible for a Roth IRA, but non a deductible IRA.
The first thing John should do is contribute $7,800 to his 401k to get the maximum employer match of $3,900. John believes that tax rates are likely to stay the same or go up for him in the future. As a result, he makes a maximum contribution of $5,500 to a Roth IRA. He as now accounted for $7,800 + $5,500 = $13,300 of his $19,500 in savings. Because he is not eligible for a deductible IRA, he will contribute the remaining $6,200 to his 401k. If he had been eligible for a deductible IRA, he would have probably chose to put the max contribution, $5,500, there as he is comfortable investing on his own and wanted the broader range of investment options and lower costs.
Still have questions? Feel free to use the comments section to ask away.