Retirement 101: Everything You Need to Know

Libby Kane
Posted

You know what’s awesome?

Retirement.

No, really. Imagine it: Waking up every day to head to your favorite yoga/art/synchronized swimming class. Catching up with friends daily. Starting (and finishing) every book or movie that catches your eye.

It’s the ultimate extended vacation, and the best part is, by the time you get there, you’ve already paid for it. You know how that happened? You started today.

No, really, today. There’s an important deadline you need to know: April 17th. This year, it’s the deadline to contribute money to a Roth or traditional IRA for 2011—in other words, if you didn’t get around to saving the maximum you could for retirement last year, you still have this window to do so. (The maximum contribution for 2011 is $5,000—unless you’re over age 50, in which case you may contribute up to $6,000.)

Now that you know that, want to make sure you’re on the right track for retirement? Don’t worry, we’ll walk you through everything you need to know, right here and now.

So go ahead, start stocking up on sketchbooks.

Your Options

To set the stage, let’s refresh our memories about the main types of retirement accounts available to us. There are three: the 401(k), the traditional IRA and the Roth IRA.

401(k)

A 401(k) is a free retirement account you can only get through an employer, and it holds money taken directly from your paycheck. Sometimes, said employer also contributes money to your retirement fund—that’s called “matching.” Traditional 401(k) plans grow tax-deferred, meaning that you’ll pay taxes when you take the money out, not when you put the money in.

Traditional IRA

A traditional IRA is set up so that your contribution each year is tax deductible (if you’re under a certain income limit*), and you aren’t taxed on the income you make as it grows. You pay those taxes when you withdraw it for retirement, which you’re required to begin doing at age 70½. Anyone can open a traditional IRA.

Roth IRA

The Roth is different from the traditional IRA in that you pay taxes upfront at today’s tax rates. In return, you never have to pay taxes on your investment earnings! This is huge. Consider the following example:

If you’re contributing $150 per month to retirement, your account could hold about $78,000 after 20 years**. Over half of that (about $42,000) is investment earnings–the money your contributions have generated just by being in the account. With a Roth IRA, you won’t need to pay taxes when you take out any of that $78,000. With a traditional IRA, you’re taxed on the entire sum, the $78,000. While there is an income limit to open a Roth IRA, anyone can convert her traditional into a Roth (more on that later).

To figure out which account is right for you, use our flowcharts below. There are two, based on the two most common tax filing scenarios: whether you file your taxes singly or are married and file jointly. Click on the flow chart that fits your tax status, and follow the questions to find out the best way for you to allocate your retirement money.

These flow charts have been updated to reflect 2013 rules; here are the 2012 charts for filing taxes singly and for married filing jointly.

The Fourth Option

If you’ve maxed out your 401(k) and Roth or traditional IRA, you have one more option: a non-deductible traditional IRA. For more on this option, see our guide. 

If you’re a married, stay-at-home mom, consider opening a spousal IRA. More on that here.

‘But I Only Have $1,000!’

Even if you feel like you don’t have a ton of money to invest, never fear. LearnVest Financial Planner Stephany Kirkpatrick CFP (R) knows exactly what you should do, no matter how much you have. “Even if you can only save 1% of your paycheck, you should be saving for retirement,” says Stephany. “Especially if your company will match your 401(k) contributions!”

(Of course, we don’t expect you to have $1,000 just sitting around, waiting to be invested. You’re likely contributing to your accounts automatically from your paychecks, so the following sums are the amount you’ll have contributed to your retirement by the end of the year. Note: Each of the following scenarios applies to those who are filing their taxes as single.)

If you’ll have $1,000 …

First and foremost, max out your company’s 401(k) match by contributing however much money your employer has pledged to match. Getting an extra $500 per year in free money could equal as much as $21,000 in 20 years!** And it didn’t cost you a thing. If you don’t have a company match, open a Roth IRA (as long as you’re within the salary limit) and lock in today’s tax rates.

If you’ll have $5,000 …

You’re in good shape! That’s actually the most you can save in a Roth IRA each year. First, max out your company’s 401(k) match, if there is one available, then dive into a Roth IRA with the remaining funds. If you don’t have a company match, open a Roth IRA and lock in today’s tax rates. Putting aside $5,000 today could mean about $217,000 in 20 years**.

If you’ll have $10,000 …

If you have a 401(k), split your $10,000 between your 401(k) and a Roth IRA so you can save the full $10,000 (since a Roth caps out at $5,000 if you’re under 50). If you don’t have a 401(k), then put $5,000 into a Roth IRA and $5,000 into a brokerage account. Your non-deductible IRA won’t give you an immediate tax break–it will only grow tax deferred. But it’s still a good deal, since it lets you save extra!

If you’ll have more than $10,000 …

Put $5,000 into a Roth IRA and the rest into your 401(k). You could save up to $22,000 a year using this combo … which could turn into more than $950,000 in 20 years**. If you’re above the income limit for a Roth, substitute a non-deductible IRA and a taxable brokerage account.

Should I Convert My Traditional IRA Into a Roth?

In 2012, anyone, regardless of income, can convert a traditional IRA to a Roth IRA. Converting doesn’t mean withdrawing any money from the account–it just means changing the type of account you’re using. When you convert, you have to pay income taxes on both the contributions you’ve made to the account and the interest it has already earned (you would file Form 8606 with the IRS) unless you’re converting a non-deductible IRA. But from that day on, you will only pay taxes on contributions when you pay your regular income tax, and you won’t be taxed when you remove the money down the road.

The younger you are, the more often it will make sense to convert to a Roth IRA because you’re likely in a lower tax bracket and will pay a lower tax rate than when you’re retirement age. Instead of paying a (likely) higher tax rate on your contributions and investment earnings later, you can pay taxes on your contributions only–not your earnings–today, though of course some rules apply. Your earnings will never be taxed.

Before you make the decision, consider the following:

  1. Do you have the money to pay the taxes on the conversion? You should only convert if you have the money on hand to pay the extra taxes for converting from traditional to Roth IRA. This money should be outside of your retirement savings–you shouldn’t be withdrawing from your retirement fund to afford the taxes on the conversion, as that means you’ll have less in your retirement fund.
  2. Will converting put you into a higher tax bracket, since the conversion amount is treated as income for 2012? (To figure out your tax bracket, consult our chart or consider asking your CPA.) If converting a small retirement fund means you’ll jump brackets and suddenly owe much more in income taxes, it might not be worth it. Previously, you could spread the tax burden over two years, but that policy ended in 2012.
  3. Are your taxes likely to be higher or lower at retirement than they are today? There’s a good chance your tax rate will increase over time as your pay goes up, and as tax laws change. If you’re under 50, you probably have at least ten years until you retire–and your taxes will likely be higher by then.

You can also put your information through a calculator to help you decide. We like this one from Wells Fargo.

*While the 401(k) and non-deductible IRA don’t have income limits, while the Roth and traditional do. You can contribute to a Roth IRA as long as your income is less than $110,000 if you are single or $173,000 if you are married. For a traditional IRA, you can only deduct if you aren’t covered by a 401(k) at work and your income is below $58,000 single or $92,000 if you are married.

**These numbers have been calculated using 7% interest.

Update, July 30, 2012: The original flow chart for this article did not specify that the income threshold for IRA contributions was the modified adjusted gross income. Additionally, it did not include a scenario for making partial contributions for those whose modified adjusted gross incomes fall between $110,000 and $125,000. The current chart accounts for those scenarios. The article text also has two corrections: If you have $10,000 and no 401(k), you should put $5,000 into a Roth IRA and the other $5,000 into a brokerage account, not a non-deductible traditional IRA. If you have more than $10,000 and are above the income limit for the Roth, you should substitute with a non-deductible IRA and a taxable brokerage account.  

More From LearnVest

Want more of where that came from? Learn about Roth IRA Movement Day, which is today!
Want to know how much your money will grow for retirement? Use our sliding tool.
Don’t be intimidated by retirement. Take control of your money with Take Control Bootcamp.

  • Melinda

    My one issue with reading any article like this is that I work for a non-profit and have a 403b.  I would love to read anything about those too!

    • Kay C

      Yes, any info on 403(b) would be great. Great article. It was exactly the info I’ve been looking for and concisely written.

  • AW

    This article doesn’t cover the Roth 401k some employers offer… I feel that it’s the best of both worlds! Benefits of a roth account plus employer matching.

    • Jenna

      I have a Roth 401(k) through my employer (with matching), and I love it!

  • Anonymous

    This was SO helpful! I have a 401K (without matching, unfortunately) plus a pension-type plan through my employer. I have been interested in the Roth IRA as well, but was not sure I could have one in addition to what I already have. This was concise, comprehensible information without being overwhelming and confusing and gives me a good place to start.Thank you!

  • Voodoolady

    I agree, you should also add 403bs to the article!

  • KEO

    what advice would you give to students about saving for retirement?
     As a first year med student. I have no employer… no 401k.. nothing but lots of student loans and nannying money!

    • M4

      I am a fourth year med student… if you CAN save anything, it might be worth it to contribute to a Roth IRA. Because I could barely live on our 20K/year budget, I haven’t been able to save anything. But I start residency in June and llok forward to beginning my savings! 

  • Victoria

    Hi I am a 20-yr student who has saved the majority of her money from summer jobs and on-campus jobs. I opened a Roth IRA this year with Bank of America, but the interest rate seems pretty low. Does anyone know how I can switch my Roth IRA to another institution with a higher rate? Thank you in advance!

    • Anonymous

      Hi Victoria — I’m answering on behalf of LV Financial Planner Sophia:
      It is so awesome that at age 20 you already started your Roth IRA! You are going to be so glad that you did! It sounds like right now your Roth IRA is either in a money market account or a CD. Since it sounds like you’re interested in investing the money, (as you should be) I would open a Roth IRA at a discount brokerage firm, such as Schwab or T. Rowe Price. You can do this online and their customer service departments can help you over the phone. Be sure to check if these places require a minimum balance.  Often times they will waive the minimum balance with a monthly contribution.  Once the account is open, you can do a Rollover from your Bank of America account to your new Roth IRA. If your Roth IRA is in a CD, check with Bank of America to see what the penalties are for getting out of the CD early. If it’s minimal, it may still be worth it to do a rollover because you really need to be investing the money for your retirement if you are going to keep up with inflation!  Remember, you can currently put up to $5,000 a year in a Roth IRA, so keep socking away those dollars now and you could retire a millionaire! Take the Financial Basics Bootcamp for more great information on investing for retirement!  Happy investing!

      • Victoria

        Hi Libby! Thank you so much! This was really helpful!!

  • M4

    So I am finishing medical school, and for he next 4 years I will be making somewhere between 50-54K. My employer does not offer a 401K, so I will start contirbuting to a Roth IRA.

    After the next 4 years, however, I will be making at least 200K a year, and will probably never again be eligible to contribute to a Roth IRA. Does the money I put in the Roth IRA just sit there until I retire? Would it be better to start contributing to a traditional IRA and stick with that once I’m making >110K? Thanks!

  • kay

    Why would you assume 7% interest?  When exactly do you think that will be offered? 

    • laurashin

      Hi Kay,

      Great question! That rate isn’t “offered” by anyone. It is based on the average historical return of the stock market, since your retirement money will be invested. Keep in mind it is an average — it may not be the case for your investments, or for any given year, but for most people, it will likely be about that over the long run. Let us know if you have any other questions.

      Laura

  • Carolyn

    I was laid off my job over a year ago. I have a 401k that is worth about a year of my paycheck. Is it possible to change the 401k to a Roth IRA? I will now continue to be at home as a spouse. What is the best bang for my buck, so to speak.

    • LibbyKane

      Hi Carolyn: Our financial planners say that converting a 401(k) to a Roth IRA in a year when your income is substantially lower than normal is a great opportunity, since the conversion is treated as income in the year you convert it.  The lower your income, the lower the tax to convert.  However, you should also carefully consider how you will pay the conversion tax, particularly if you do not have any income or savings.  It is not ideal to convert unless you can pay the taxes from money that is not otherwise allocated to specific goals for this year.  You should not pay the conversion tax with a portion of the balance in the account as it may take many years of growth to recoup that amount and the portion used for taxes is treated as an early withdrawal subject to federal and state taxes and penalties.  The final section of above gives some great things to consider before doing a conversion, including a calculator to help you weigh the options.

      • Carolyn

        Thank you so much for your help. I certainly do NOT want to pay more taxes than necessary. I think I will leave well enough alone for now. At this time, I think that is the safest move.

  • Katie Grace

    so i currently have a 401K with an employer match if I contribute at least 5%. I have a Roth IRA but don’t contribute much. Currently I contribute 11% pre-tax income to my 401K and my employer puts in 3% for a total of 14%. So, what you’re saying is, I should cut back my contribution to 5% and calculate the “extra” that’s in my paycheck after taxes and contribute that to my Roth IRA up to the max and if I contribute more than the max calculate how to contribute the additional back to my 401K?