Your decision about which retirement account to invest in is very important. Your choice could affect how much money you end up with in your later years.
To help you pick the right place for your retirement funds, there are three questions to ask yourself. Here's what they are.
Image source: Getty Images.
1. Do you have access to a 401(k) match?
The first and most important question to ask yourself is whether your company offers a 401(k) with matching contributions. Matching contributions means your employer contributes some money when you do, although the specific rules vary for how much. For example, some employers might offer a 100% match on contributions up to 4% of your salary and others may offer a 50% match on contributions up to 5%.
Whenever you have a 401(k) with matching contributions, this should be the first retirement account you put money into. You should invest at least enough in this account to earn the match because that is basically free money. If you get a 100% match and you invest $500 of your own money, you will get another $500 from your employer and immediately get a 100% return on your investment.
You also get a tax deduction for contributing to a 401(k). This means the government helps to subsidize your retirement savings. So you get the double benefit of both the matching funds and the fact that your contribution is tax-advantaged. That makes starting with 401(k) contributions a no-brainer.
2. What do you want to invest in?
You'll next need to think about what you want to invest in. Chances are good your 401(k) offers you a limited array of investment options. You'll likely have access to some target-date funds and a few other funds that track broad market indexes or provide exposure to specific types of assets such as small-cap, mid-cap, or large-cap stocks.
You will not generally be able to invest in individual stocks in a 401(k), nor will you be able to invest in alternative assets such as cryptocurrency. You are stuck with the investments offered in your employer's plan even if they have higher fees than similar alternatives or aren't exactly what you'd prefer to put your retirement money into.
If you want more choices for where to invest, you can choose to use an IRA for your retirement dollars, as IRAs also provide tax breaks. You will still want to invest enough to earn the full employer match in your 401(k), but if you have extra money beyond that, you can divert it to an IRA as long as you qualify based on income limits.
An IRA also has a lower contribution limit than a 401(k). So, if you max out the amount you're allowed to invest in it, you'll probably want to switch back to your 401(k) for any extra contributions so you can get the maximum tax breaks possible.
3. How do you think your tax bracket will change over time?
Finally, consider what you think will happen to your tax rates as you age. This will help you choose between traditional and Roth accounts.
Both IRA and 401(k) accounts come in two forms: traditional and Roth. Although some workplaces may only offer traditional 401(k)s, a growing number offer both account types. And, regardless of whether your employer does or not, you'll have your choice of which kind of IRA to invest in. This choice requires careful consideration because there are big differences between them.
With a traditional account, you contribute with pre-tax dollars. Your contribution doesn't reduce your take-home pay quite as much as the full contribution amount since you're also paying less in taxes. But you must pay taxes on withdrawals. If you think your tax rate is higher now than it will be in retirement, this is likely the right kind of account.
With a Roth, you don't get that upfront tax savings but you can take money out tax-free as a retiree and your Roth contributions won't be counted when determining if your income exceeds the level when Social Security becomes taxable. So if you think you will have a higher income and/or be in a higher tax bracket as a retiree, this is likely the best retirement plan for you to contribute to.
By considering these issues, you can make an informed choice about a traditional or Roth account, and decide whether your money belongs in a 401(k), IRA, or both. It's worth taking the time to think about these questions so you can make the most of your retirement savings.
