You’ve heard this all before about saving for retirement: Do it early in your career, and your life, for that matter; “pay yourself first” with automatic retirement contributions; contribute to your employer’s 401(k) plan if one is available; open individual retirement accounts (IRAs); and make sure your portfolio is tailored to your goals and risk tolerance. Sounds good, right? But how do you go about doing all of that?
Here’s a three-step plan to show you how to contribute to a 401(k) and IRA to maximize multiple tax-advantaged retirement accounts down the road. Remember, however, that the rules in place today on issues like 401(k) contribution limits and IRA contribution limits are likely to change over the years.
1. Contribute to a 401(k).
If your employer offers a 401(k) with a matching contribution, you might want to jump on it. An employee match on your contribution can be considered “free money,” and who wants to leave a freebie on the table? How much of the matching funds you receive if you leave your employer is often tied to your longevity at the company (aka a “vesting schedule”), so it’s important to know the specifics of your company’s plan.
There are no income restrictions for participation, but there are limits on how much you can contribute, according to the Internal Revenue Service. If you’re under age 50, the 401(k) contribution limit for 2018 is $18,500. Those 50 and older are allowed to up the ante with an additional $6,000 catch-up contribution, for a total of $24,500. Remember this, too: Your employer’s matching contribution doesn’t count toward the annual limit.
2. Supplement with IRAs.
Even if you have a work-sponsored 401(k) or a similar plan, you may still contribute the full $5,500 to a traditional IRA, as long as your income is at least that much. However, the contribution may not be tax deductible depending on your adjusted gross income. Roth IRAs—which have a different tax treatment on the way in and on the way out—also have an income threshold for contributions, but not one bound by an employer’s retirement plan contributions. Roth contribution eligibility is determined by your modified adjusted gross income (MAGI). Your contribution can be reduced or phased out if your income reaches certain levels. For 2017, the phaseout begins at $118,000 for single filers ($186,000 for married couples) and the income cap is $133,000 for single filers (and $196,000 for married couples filing jointly). For 2018, the limits are $2,000 higher for single filers and $3,000 for married filing jointly.
Traditional IRAs are tax deferred. That means you pay the taxes on interest or gains when the funds are withdrawn during retirement. Roth IRAs are funded with post-tax dollars, so you’re not taxed (even on account earnings) once the money comes back to you if the distribution is qualified. The limits for 2017 and 2018 are the same: $5,500 a year if you’re under age 50, and $6,500 a year if older. Remember, you can never contribute more than your annual income. For example, if you earned $4,000, the most you can contribute is that amount. Contributions for non-working spouses are based on the income of the working spouse.
3. Open More than One IRA.
Because they're on separate sides of the tax spectrum, traditional and Roth IRAs can play off each other in retirement. Having a combination of taxable and tax-free income may help you create a withdrawal plan that might potentially minimize your tax bill. And while you'll need to start taking required minimum distributions from your traditional IRA once you turn 70 1/2, this rule doesn't apply to Roth IRAs so your money can stay invested longer. What’s more, multiple IRAs may help better diversify your portfolio, depending on the investment choices you select for each one.
There’s one caveat to owning and investing in more than one IRA: The annual limits on your contributions are cumulative between all IRAs you fund, not each individual one. You can split your contributions any way you want as long as you don't exceed the annual limit and meet the income rules. For example, if you contribute the full $5,500 to a traditional IRA, you can't contribute to a Roth IRA in 2018.
Remember that pulling money out of your 401(k) or IRAs early can be a pricey proposition: the IRS slaps on a 10% penalty for early distributions (generally before age 59 1/2); if the money is pulled from a traditional IRA or 40(k), there are income taxes to face. For Roth IRAs, the 10% penalty and taxation apply only on earnings withdrawn generally before age 59 1/2. Depending upon what period of your life the funds are withdrawn, the opportunity costs of pulling money out early could put a big dent in your retirement nest egg because those assets are no longer growing tax deferred. (There are exceptions. Check with a qualified financial planner for guidance.)
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