You know what's awesome?
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.
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.
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.
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.
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.
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!"
Get started with a free financial assessment.
Get started with a free financial assessment.
(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:
- 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.
- 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.
- 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.
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