For the past 20 years, most individuals have saved and invested for retirement on their own because company pension plans are largely a thing of the past. Living on Social Security alone during retirement isn’t appealing for most of us, since the maximum benefit is around $40k/year for 2022.1 But how much and where should we invest for retirement? The short answer: Most individuals should be saving and investing about 15% of their income into a retirement savings/investment plan such as an IRA or 401(k) or 403(b), or some combination.2
Companies typically offer some form of retirement savings plan with employee contributions coming directly out of their paychecks. These are many times 401(k) or 403(b) plans but could also be 457 or deferred compensation plans, depending on the employer and type of business. Many but not all companies will match a specific percentage of their employees’ contributions, which if you’re lucky enough to have this option, you should be taking advantage of it because this is “free money”. Investment options for these types of retirement savings plans are generally selected by the employees from a pre-defined list of 15 to 50 mutual fund or similar options. The IRS does set annual contribution limits for the employee portion, which for 2022 is $20.5k for employees under age 50 and $27k for employees aged 50 or older.3
Many but not all companies will match a specific percentage of their employees’ contributions, which if you’re lucky enough to have this option, you should be taking advantage of it because this is “free money”
If you work for a small company, or for yourself as an independent contractor, you may not have a company-sponsored 401(k) or 403(b) or 457 plan available. In this case, you could set up a Simplified Employee Pension, or SEP, plan if you own your own business or work for yourself as a consultant or entrepreneur. Small companies sometimes do offer a SIMPLE plan, which operates much like a 401(k) but has lower annual contribution limits and requires employers to match at a specific safe-harbor level. But if none of those is available, employees can contribute to their own Individual Retirement Account, or IRA, set up directly with a brokerage firm or bank. Annual IRA contribution limits are even lower than the others mentioned, and sometimes higher income individuals may be prohibited from making contributions altogether (e.g., Roth IRA) or may lose the tax deduction (e.g., traditional IRA). Investment options in IRAs are virtually unlimited, with most any stock, bond, ETF, or mutual fund available.
when it comes to saving for retirement, sooner is always better than later
But later, in retirement, all monies distributed from these plans are considered taxable income. The tax benefit comes on the front end when contributions are made. Once a retiree turns 72 years old, Required Minimum Distributions (RMD’s) apply, necessitating withdrawals be taken according to an IRS table.
In contrast, Roth IRAs do not provide a front-end tax benefit, meaning employee contributions to Roth IRAs are not deductible. But unlike traditional IRAs, Roth IRA distributions come out tax-free during retirement if the Roth account has been in place for 5 or more years and the employee is 59 ½ years old or older. Roth IRA tax benefits are accrued on the back end, meaning during retirement when distributions are taken to supplement Social Security income. Today many employer-sponsored retirement plans also allow employee 401(k) contributions to be designated as Roth. This is an excellent way to build up a large retirement account which may be available tax-free in retirement. And because monies inside a Roth account have already been taxed, no RMD’s are generally required.
Which is better – Traditional or Roth? Both, actually! Using either or both retirement savings/investing vehicle is better than not saving/investing at all, and when it comes to saving for retirement, sooner is always better than later, and higher contributions are always better than lower. If I were advising a 25-year-old employee just starting out and making $50k per year, I’d suggest building up the Roth 401(k) and/or Roth IRA as much as possible since a tax deduction now isn’t as critical at this juncture. But if my client was 58 years old and making $650k annually, I’d suggest they use all the tax deductions they can get right now, because they’re in a very high tax bracket already. This means using a traditional 401(k) or IRA for this client would be my suggestion.
1 Social Security website https://faq.ssa.gov/en-US/
2 What Percentage of your Salary Should go Toward Retirement?, Investopedia, by Tim Parker, March 30, 2022
3 401(k) Contribution Limits Rising Next Year, by Jackie Stewart and Elaine Silvestrini, Kiplinger, September 23, 2022
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Scott MCClatchey, CFP®
Scott McClatchey is a wealth advisor and CERTIFIED FINANCIAL PLANNER™ with WWM Financial in Carlsbad, CA, an SEC-registered investment advisor. He can be contacted by phone on 760-692-5190 or by email at scott@wwmfinancial.com .
WWM Financial is an SEC Registered Investment Advisor.
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