Retirement Planning for the Middle Class Part 1
This is the first in a series of posts about retirement saving. It is scary how many Americans have no retirement savings. Many more have a little bit but are not on track to retire comfortably. The most important thing about retirement savings is simply starting saving and save every month. You have heard it before, but I cannot stress enough how important the simple act of saving is. If you haven’t started saving, it is not too late. Start now.
Here are some things to keep in mind when deciding what vehicle to use to save for retirement. Remember you should always consult your investment professional and your tax adviser because your situation is unique.
Should you be using a 401(k)? The answer is always yes if your company is matching at all. The first place to save is always with your company to get the full match. There are still a few things to consider. 1) Do you qualify for the company match? Most companies with a 401(k) do not allow you to save in the first year and there are often long vesting schedules that require you to work for a company more than 5 years for you to get the full vesting. If you don’t qualify for your company’s plan or if they don’t match, that does not mean you should not save for retirement. You are still getting older even though your company does not have a plan. So where should you be saving if you don’t have a company plan or they do not have a match?
IRA is the default for many people who have no company match. Is that tax deduction worth the future tax bill along with the handcuffs the IRS puts on your IRA investments? First let’s address the IRA restrictions. If you put money in an IRA you get a current year tax deduction. In exchange for that, you are not allowed to touch that money until you are at retirement age without a significant penalty. I don’t necessarily think the penalty is a bad thing because it does deter enough people from spending their retirement on a vacation home or a boat, but it is still a restriction put on your money and investments. Now let’s address the tax situation. In exchange for the current year tax deduction, you will be paying ordinary income tax rate on the entire amount when you pull the money out.
Understanding the difference between ROTH and Traditional IRA’s
The age old question of Traditional IRA vs ROTH IRA is actually very simple to answer. It entirely has to do with your current tax bracket vs your projected future tax bracket. Let’s assume you are in a 15% tax bracket and have $2,000 to invest in a Traditional IRA. Because this $2,000 investment would give you a $300 tax deduction, you would only be able to put $1,700 in a ROTH IRA for the two investments to be equal in terms of after tax dollars. For this example we will assume a 30 year old who will retire at 65 (35 years) and an 8% rate of return (which I believe is extremely conservative as the stock market actually averages between 11% and 12%). This investment will yield a total of $29,570, which you will pay tax of $4,435. The after tax amount comes out to be 25,135, which is exactly the same amount the $1,700 would yield in a ROTH IRA.
Let’s change the assumptions a little. Instead of a retirement tax rate of 15%, assume you are now in a 25% tax bracket. Now the tax bill on the Traditional IRA increases to $7,393 for a net of tax amount of $22,178. The ROTH still yields you $25,135. In this situation the ROTH is better by $2,957.
One final change, let’s say your tax bracket drops in retirement to 10%. Now the tax on the Traditional IRA is only $2,957 for a total after tax investment of $26,614. Here the Traditional IRA is better by $1,479. So you can see that if tax brackets don’t change, the Traditional IRA and ROTH IRA’s are exactly the same. If your tax rate goes up the ROTH IRA is better and if your tax rate goes down the Traditional IRA is better.
The after tax effect of the 401(k)
Finally let’s assume your company matches 50% of your contributions. Under the same assumptions above with a 15% tax bracket both currently and in retirement, the total retirement amount $44,356 with anafter tax amount of $37,703. This is by far the best of all these scenarios.
For all these examples we only used one year of savings. If you were to scale that up to saving annually under this last assumption instead of one time, the totals on the 401(k) with a match would be over half a million dollars on a saving of just $166 per month starting at age 30 and ending at age 65. If you can start earlier and save a little more it will be significantly higher.