What type of Retirement Account is Best?
By Tim Fullerton

As US wage earners, we enjoy a variety of vehicles for saving for retirement in a way that defers or eliminates taxes. It is not obvious to the naked eye which option offers the best savings, or if a retirement account offers any savings at all. This article, and the web-based calculator that accompanies it, outlines the kinds of plans that are available and which are appropriate for various circumstances.

Types of Plans

This article breaks the options into two categories ?Traditional-style accounts and Roth-style accounts. In a Traditional-style account, contributions are tax deductible. You pay taxes when you withdraw the money from the accounts. Traditional-style accounts include Traditional IRAs, 401(k)s, SIMPLE IRAs, SEP IRAs, and most Keough accounts. A Roth-style account requires that you pay the taxes now, but the account?s investment income accrues tax free. These accounts include Roth IRAs and Roth 401(k)s.

Roth-style plans

Roth-style accounts are generally better for most people most of the time. They are better particularly when:

• You are in a lower tax bracket now, and expect to be in a higher tax bracket when you take distributions, and
• You are under about 30.

Paying taxes on your income is painful -- more so when you are still not making very much. However, if you can withstand it and you save all you can in a Roth account, you will have more lifetime buying power in the end. That is because distributions from Roth accounts are tax free. If you are in a significantly lower tax bracket when you are paying in, you pay significantly lower taxes on that income.

Also, if you are very young, the compounding effect allows the value of those early investments to grow very large. For example, if you pay $1000 in when you are 21 and it grows at 10% annually, it will be worth $117,391 if you hold it until age 71. So you will pay taxes on that $1000, and will withdraw $117, 391 tax free.

As Roth plans go, you have two choices ? the Roth 401(k) and the Roth IRA.

Roth IRA

The Roth IRA is a plan that you set up individually through a bank, brokerage, or other financial institution. It allows you to contribute up to $4000 of after-tax income per year if you are under 50. If you are 50 or over, you can contribute up to $5000.

As with any Roth-style plan, contributions are non-deductible, but distributions are entirely tax-free You may contribute to a Roth IRA regardless of any employer-sponsored retirement plan, but you become ineligible to contribute to a Roth IRA past certain income thresholds:

Roth 401(k)

The Roth 401(k) is a better option, if your employer sponsors it. It allows you to contribute up to $15,000 per year in after-tax dollars, $20,000 if you are 50 or over. Like the Roth IRA, contributions are not deductible, but distributions are tax free. Unlike the IRA, eligibility to participate in the 401(k) does not phase out past certain income levels.

Traditional-style plans

Traditional-style accounts are generally better when:

• You expect to be in a lower tax bracket when you take distributions
• You are older, and close to taking distributions
• Your income renders you ineligible for Roth contributions
• Your employer provides any sort of matching contribution or other incentive

Hopefully, you are planning to make things so that your income in retirement is high, but it does not work out that way for everybody. If you are confident you will be in a lower tax bracket in retirement than now, it is usually better to put paying the income taxes off until then. Also, if you expect to be taking distributions within about sooner rather than later, having a tax benefit now tends to outweigh the tax benefit later. If you have the high-class problem of making too much to qualify for a Roth IRA, and your employer does not offer a Roth 401(k), your only choice may be Traditional-style accounts.

Traditional IRA

In a traditional IRA, you can contribute up to $4000 of your taxable income per year if you are under 50, and $5000 per year if you are 50 or over. Contributions are tax deductible, but distributions are taxed as income. You also lose deductibility if you contribute to an employer-sponsored retirement plan and earn more than certain thresholds:

If you are not paying into an employee-sponsored retirement plan, but your spouse is, the rules are a little different:

Traditional 401(k)

In a 401(k), you can contribute up to $15,000 of taxable income per year if under 50, and $20,000 if 50 or over. You are eligible to contribute to your own Traditional or Roth IRA as well, although you may be disqualified from deducting a Traditional IRA contribution.

SEP IRA

 A SEP IRA is likely the best choice when you are self employed and have no other employees. Through your business, you can contribute up to 25% of your taxable income, to a maximum of $44,000 per year. If you are also participating in other defined contribution plans, the total contribution must be at or below 100% of compensation, or $44,000.

A SEP IRA is not really a deferral of compensation. It is a benefit that your business gives to its employees in addition to their wages. If you have no other employees besides yourself, it amounts to a deferral of compensation for you, because your compensation for tax purposes is the income from your business. If you do have employees besides yourself, though, you cannot discriminate against them. You must give them the same benefit you give yourself.

SIMPLE IRA

 A SIMPLE IRA is another option for the self-employed. Through your business, you can contribute up to $10,000 of your taxable income per year if you?re under 50. The business must also do one or the other:

• Match your contribution dollar for dollar, up to 3% of your compensation for the calendar year.
• Make a non-elective contribution that is 2% of your income

If you participate in any other elective deferral plan, the SIMPLE IRA counts toward the $15,000 annual limit.

Non-retirement accounts:

In theory, sometimes a Traditional IRA is not worthwhile at all. If you are under 30, in a low tax bracket now, you expect to be in a high tax bracket when you take distributions, and you have already contributed everything you are eligible to contribute into a Roth, it may be better to simply invest in stock outside of a Traditional retirement account. That happens because distributions from Traditional accounts are taxed as income (as much as 35%), and profit from the sale of stock are taxed as capital gains (as much as 15%). Recall the compounding example from before. $1000 compounded at 10% for fifty years equals $117, 391. It should be easy to see how paying income tax on $1000 plus 15% capital gains tax on $117,391 is less expensive than saving the income tax on the $1000 and paying 35% income tax on $117,391.

This assertion has some qualifications. In order for it to work, the non-retirement portfolio must be managed in an extremely tax-effective manner. Also, whenever an employer-sponsored plan has any sort of employer match; you really ought to take it.

Calculator

To get a general idea how you should prioritize investment in Traditional versus Roth accounts, try our IRA Picker. Given your individual situation, it compares the returns on contributions to and withdrawals from a Roth-style account, a Traditional retirement account, and a portfolio outside of a retirement account. Specifically, it compares contributing $4000 per year into each type of account until you reach age 70, and making equal annual withdrawals from each account afterward.

This article and the IRA Picker are for informational and illustrative purposes only. Neither is intended to be construed as investment advice. If you have questions, we urge you to contact us to deal with the complexities of your situation.

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