If you have more than one type of retirement savings plan available to you, where and in what order should you contribute to the accounts?
First of all, most employees have some tax-deferred retirement savings accounts that go by many names – 401(k), 403(b), 457 and deferred compensation. They are collectively referred to as qualified retirement plans, or QRPs.
You should choose a QRP as the place to start with your retirement savings if your employer matches your contributions. A common match is 50 cents for each dollar you put in, up to 6% of your pay.
I understand that, if you’re math-averse, that last sentence comes out sounding like Charlie Brown’s teacher – so here’s an example: If you make $50,000 per year, and you contribute 6% (which is $3,000) to your QRP, you can receive a $1,500 match from the employer. At the end of the year, you’ll have a total of $4,500 in your retirement savings account.
You can see why the QRP is a good place to start. With the match, you make a 50% return on your money, even before you invest it in the market.
Another bonus is that the contributions are pre-tax, costing you less to save in the QRP. To illustrate, if you are in the 25% income tax bracket, the $3,000 in the example above decreases your take-home pay by approximately $2,250 for the year ($3,000 x 25% = $750, $3,000 – $750 = $2,250). When you include the employer match, you actually double your money.
After you contribute to your employer’s matching amount in your QRP, the next savings plan you should fund is a Roth individual retirement account, or Roth IRA.
A Roth IRA allows you to contribute, for 2015, up to $5,500 per person ($6,500 for folks over 50). You can open an account with a discount brokerage, a mutual fund company, an insurance company or your local bank.
The biggest advantage of saving through a Roth IRA is tax-free withdrawals after the age of 59-and-a-half. That’s right, tax-free.
Before 59-and-a-half, you can withdraw all of your contributions at any time with no tax consequences, but earnings – investment gains, dividends and interest – are subject to taxes and penalties.
However, for certain qualified purposes, such as purchase of a first home, education expenses or health care expenses, you can use the entire account without paying tax and early withdrawal fees.
The QRP contribution deadline is the end of the calendar year, December 31, but you have until April 15 to make contributions to a Roth IRA for the previous year.
Now, if you contribute enough to your QRP to max out the employer match, and you also fill the Roth IRA limit, you will have considerable savings for the year. For example, a couple, Dick and Jane, is saving for their retirement. Dick earns $50,000 and Jane earns $30,000. Their employers match 50 cents on the dollar for the first 6%.
The first step is to contribute that 6% to each of their plans. That’s $3,000 for Dick and $1,800 for Jane. The employers’ matches are $1,500 and $900. Then, each of them can contribute $5,500 to a Roth IRA. This comes to a total of $18,200 for the year.
After maxing the Roth IRA, you should make additional contributions to your employer’s QRP, up to the limit allowed by your employer or by law. For 2015, the maximum amount that you can contribute to a 401(k) plan is $18,000, and there’s a catch-up provision amount of $6,000 for folks over 50.
There are plenty of other options for retirement savings. The following may not apply to your situation, but I list them for the sake of education:
Traditional IRA. If you don’t have access to an employer-sponsored QRP like a 401(k), you can reduce your tax burden a bit by contributing to a traditional IRA. The limits on contributions are the same as those of Roth IRAs ($5,500 for 2015 plus the $1,000 catch-up for 50-plus people). Keep in mind, though, the limits are for all your IRAs, which means you can only contribute the maximum amount in either a Roth IRA or a traditional IRA, or a combination of the two.
Non-qualified plans. Many employers offer savings plans that go above and beyond the QRP limits. Each plan is different, so you have to check the provisions to determine if the plan is appropriate for you.
Employee stock purchase (or ownership) plan. Within these plans, you can buy your employer’s stock at a discount. Assuming that you are not over-exposed to your employer’s stock (rule of thumb: no more than 5% in any single company), this may be a good place to contribute some retirement money. Keep a close eye on your exposure as well as your company’s future prospects. Remember Enron, whose demise harmed many employees who had a huge amount of their investments in the energy company?
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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
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