The more money you save for retirement during your working years, the more comfort you'll enjoy as a senior. Not only will saving aggressively during your career buy you a more rewarding retirement, but it will also spare you the financial struggles facing so many of today's retirees -- especially because Social Security won't provide enough income to live on.
When it comes to retirement savings, there are two popular tax-advantaged plans to choose from: the 401(k) and the IRA, or individual retirement account. Here, we'll review how these accounts work in 2019 and the steps you can take to use them wisely for your retirement.
On a table outdoors, an alarm clock sits next to successively taller stacks of coins. Next to that, a hand prepares to drop a coin into a glass jar filled with coins and labeled retirement.
IMAGE SOURCE: GETTY IMAGES.
How do 401(k)s work?
A 401(k) is an employer-sponsored retirement plan that's funded directly from your earnings. There are two types of 401(k): the traditional 401(k) and the Roth 401(k). The annual contribution limits for both types of 401(k) in 2019 are $19,000 for workers under 50, and $25,000 for workers 50 or older, and these limits apply no matter how much you earn.
Once you put money into either type of 401(k), you can invest it according to your plan's offerings. Most plans offer a variety of investment choices, ranging from conservative (money markets or bond-focused funds) to aggressive (stock-focused funds). Keep in mind that your investment options with a 401(k) is usually limited to mutual funds, as opposed to individual bonds or stocks.
The money you put into a traditional 401(k) goes in tax-free -- meaning it's deducted from your earnings on a pre-tax basis. As such, if you contribute to a traditional 401(k) in 2019, you'll save money on your 2019 taxes, and those savings will be a function of your effective tax rate. For example, if that rate is 30% and you contribute $15,000, you'll shave $4,500 off of your 2019 IRS bill.
The money in your traditional 401(k) grows on a tax-deferred basis, meaning as your investments earn money year after year, you won't be forced to pay taxes on your gains until you start taking withdrawals in retirement. Once you turn 59 1/2, you're allowed to take withdrawals from your 401(k), at which point those distributions will be taxable. You'll also be required to start taking minimum required distributions, or RMDs, once you turn 70 1/2, and those, too, will be taxable.
Roth 401(k)s work a little differently. With a Roth 401(k), the money you contribute goes in on a post-tax basis, which means there's no immediate tax break for funding your plan. Once that money is in your account, however, it grows on a tax-free basis, and the withdrawals you take in retirement aren't subject to taxes at all. As is the case with a traditional 401(k), you can access your money penalty-free at age 59 1/2 and RMDs begin at 70 1/2. But unlike a traditional 401(k), your Roth 401(k) RMDs are yours free and clear of taxes.
How do IRAs work?
An IRA is an individual retirement account that you open at a financial institution or bank. Unlike a 401(k), it's not an employer-sponsored plan; only you can contribute to it. The annual contribution limits for traditional and Roth IRAs in 2019 are $6,000 for workers under 50, and $7,000 for those 50 and over.
Like 401(k)s, IRAs allow you to invest your money so that it grows into an even larger sum over time. IRAs, however, tend to offer a wider range of investment choices than 401(k)s, so you can load up on individual stocks if you please.
The money you contribute to a traditional IRA goes in on a pre-tax basis, and it can serve as a tax break for the calendar year in which you make the contribution. In other words, if you put $5,000 into a traditional IRA in 2019, you won't pay taxes that year on $5,000 worth of income, and that money will grow on a tax-deferred basis from that point forward. You're allowed to take IRA withdrawals beginning at age 59 1/2, and RMDs begin at 70 1/2. All traditional IRA withdrawals are taxable -- that's the downside of getting the immediate tax break we just talked about.
Roth IRA contributions, meanwhile, are made on an after-tax basis, so there's no immediate tax break for funding an account. That money, however, gets to grow tax-free, and withdrawals are not taxed in retirement. Furthermore, Roth IRAs aren't subject to RMDs, which means you can let your money grow indefinitely or pass it on to your heirs.
The only problem with Roth IRAs is that higher earners don't have the option to fund them directly. Here's what Roth IRA income limits look like for 2019:
Single, head of household, or married filing separately (and you didn't live with your spouse during the year)
$122,000
$137,000
Married filing jointly or qualifying widow/widower
$193,000
$203,000
Married filing separately (and you lived with your spouse at any point during the year)
$0
$10,000
DATA SOURCE: IRS.
That said, there's a workaround for higher earners who want to contribute to a Roth IRA. If you're barred from contributing directly, you can fund a traditional IRA and then convert it to a Roth after the fact. You'll be subject to taxes on the sum you convert, but you'll then get to reap the benefits of having a Roth account.
How to maximize your 401(k)
If you have access to a 401(k) plan through work, the more strategic you are with that account, the greater your chances of retiring comfortably. Since 2019's annual contribution limits are $500 higher than they were in 2018, savers have a real opportunity to sock away a nice amount of money. Here are a few ways you can maximize your 401(k) in the coming year.
1. Take advantage of catch-up contributions. Workers 50 or older have the opportunity to make catch-up contributions in their 401(k)s. That catch-up limit is set at $6,000 as of 2019, which is why older workers have the option to set aside up to $25,000 in 2019, as opposed to the $19,000 cap for everyone else. Making catch-up contributions is a great way to boost your savings if you got started saving later in life or if your 401(k) balance is lower than you'd like it to be given your age.
As a general rule, it's smart to have about six times your current salary saved up by age 50 to ensure that you can retire. That means if you're 50 years old and earning $80,000 a year, you'd ideally want $480,000 by now. If you're looking at a balance of just $100,000, you'd be wise to start making catch-up contributions to compensate.
What might that do for your savings? Let's assume your investments average a 7% annual return during your total investment window -- that's a couple of percentage points below the stock market's average. If you're sitting on $100,000 and contribute $19,000 a year to your 401(k) until age 67, which is full retirement age for Social Security purposes, you'll end up with about $902,000. But if you contribute $25,000 for the next 17 years, you'll grow your savings to almost $1.09 million instead. All told, you'll have about $185,000 more for retirement.
2. Snag your full employer match. Many employers who sponsor 401(k)s also match employee contributions to varying degrees. Understanding how your match works will help you capitalize on what's essentially free money for your retirement plan.
When employers offer matching programs, they often do it on a percentage basis of your salary. In other words, your company might put up to 2%, 3%, or 5% of your salary into your 401(k), provided you contribute at the same rate. In other cases, companies will match a percentage of what you, the employee, put in, up to a certain limit. For example, a company might offer a 50% match on your contributions up to 15% of salary. This means that if you earn $100,000 and contribute $15,000, your company would put in $7,500. Either way, plan to contribute enough money in 2019 to get your employer match in full.
That said, be aware that your company might have a vesting schedule with regard to employer contributions. If this is the case, those employer dollars may not be yours right away. Rather, they'll become yours over a period of time. And if you leave your employer before you're fully vested, you might give up some money in your 401(k) that would've otherwise been yours.
Vesting schedules can work differently depending on how they're set up. Let's assume your employer has a five-year vesting schedule. If it imposes a cliff vesting setup, you won't get partial ownership of your employer match along the way. Rather, you'll have to stay with the company for five years until you're 100% vested or risk forfeiting any funds put into your 401(k) during that period. On the other hand, if your company has a graded vesting setup, you'll gain ownership of a portion of those matching dollars for each year you remain employed. For example, if you stay on board for two out of five years, you'll get 40% of your employer's contributions.
Of course, not all 401(k)s come with a vesting schedule. If you're lucky, you'll be vested in 100% of whatever money your employer puts into your retirement plan immediately.
3. Choose the right investments. The more strategic you are in choosing investments for your 401(k), the better they can serve you. Make sure to remember these three tips when selecting investments:
Take on an appropriate level of risk: Obviously, your goal in investing your 401(k) dollars should be to snag the best possible return on investment -- but without taking on undue levels of risk. If you're younger, you're generally safe to invest more aggressively by loading up on stock-based mutual funds. Though these tend to be riskier than bond funds, they typically produce higher returns over time. If you're older and closer to retirement, you might need to play it a bit safer by sticking to more conservative investments. That way, if the market has a few really bad years, you'll ideally lose less money in a downturn than you would with stocks, and therefore won't struggle as much to recover in time.
Diversify: Another important thing to do is diversify your investments. That way, if one sector or area of the market tanks, you might still make money in other areas, or at least not lose as much. Similarly, it pays to hold both stocks and bonds in your 401(k). If you're younger, you can generally go heavier on the former, and if you're older, you should scale back on stocks and put more money into bonds or other funds with more stability -- though if you have a high tolerance for risk, you might do just fine with a stock-heavy portfolio as well. Target-date funds can be a useful tool in both of the above regards. A target-date fund is a mutual fund that invests your money based on the date at which you plan to access it -- in this case, retirement. The good thing about target-date funds is that they simplify the investing process, all the while giving you the diversification you need. That said, they're not a perfect solution, so if you're going to choose target-date funds, make sure they align with your risk tolerance and keep tabs on their performance.
Minimize fees: Finally, keep your investment fees to a minimum by choosing index funds over actively managed mutual funds. Index funds simply track existing market indexes, like the S&P 500, and as such, you're not paying for the constant input of a professional fund manager as you would with an actively managed mutual fund. Of course, that doesn't mean actively managed funds don't have a place in your 401(k); just pay attention to things like performance so you're not overpaying for an actively managed fund when there's a passively managed index fund offering the same five-year return at a lower cost to you.
4. Use a Roth to your advantage. Unlike Roth IRAs, Roth 401(k)s don't impose income limits, so if you're a higher earner, you're free to fund one directly. The primary benefit of saving in a Roth is getting access to tax-free withdrawals in retirement, so if your 401(k) offers a Roth option -- not all plans do -- it could make your golden years less stressful.
That said, before you put money into a Roth, ask yourself whether you expect to be in a higher tax bracket in retirement versus today. If you're learning toward the former, it makes sense to pay taxes on your contributions now and reap those tax benefits as a senior. But if you think you'll be in a lower tax bracket in retirement, then a traditional 401(k) might be a more logical choice.
Of course, you don't necessarily need to choose one or the other. In some cases, it makes sense to put some funds into a traditional 401(k) and some into a Roth. This way, you're getting a partial tax break up front, but you'll also get the option to withdraw some of your savings tax-free when you're older.
How to maximize your IRA
If your employer doesn't offer a 401(k), or if it offers one that's truly lousy, your next best bet is to save for retirement in an IRA. You can make IRA contributions periodically or in one lump sum, and your strategies for maximizing your IRA in 2019 are pretty similar to those of a 401(k).
First, let's talk catch-up contributions. Though IRAs don't offer the same generous $6,000 catch-up contribution that 401(k)s allow for, an extra $1,000 a year in your account could go a long way over time. Imagine you're 50 years old with $100,000 saved in your IRA. If you were to contribute $6,000 a year for the next 17 years, you'd have about $501,000 by age 67, assuming an average annual 7% return on investment during that time. But if you were to max out at $7,000 a year for those 17 years instead, you'd have close to $532,000, all other things being equal. And that extra $31,000 could go a long way toward helping you cover a host of expenses in retirement, from travel to home repairs to healthcare.
Next, you'll want to invest your money wisely. The benefit of choosing an IRA over a 401(k) -- or getting stuck with one, depending on your circumstances -- is having access to a wider range of investments. This means you have an opportunity to load up on individual stocks as well as mutual funds. Of course, your strategy should be the same as that of a 401(k) -- score the highest returns while taking on an appropriate level of risk, all the while keeping fees as low as possible so they don't eat away at your returns. And you'll want to diversify your investments to minimize risk.
Finally, think about saving in a Roth, whether you're eligible to contribute directly or need to go the backdoor route if you're a high earner. Your strategy in choosing a Roth versus traditional IRA will differ slightly than that of a 401(k), because in this case, you're not only taking current and future tax brackets into consideration, but must also contemplate how much flexibility you want with your money. If you expect to work part-time during part of early retirement, or do something else to generate income like rent out your home, you may not need the money in your savings plan during your early 70s. Roth IRAs are the only tax-advantaged retirement plan that won't force you to take required minimum distributions, so think about whether you might want or need that flexibility later in life. This is a good savings vehicle for the longest term, as it can be used to save money to pass onto your heirs.
Ramp up your 401(k) or IRA contributions
In an ideal world, your goal would be to contribute the annual maximum to your 401(k) or IRA in 2019. But socking away between $6,000 and $25,000, depending on your age and the account you're saving in, may not be feasible if your immediate expenses are such that you can't afford to part with that much cash in the near term. If you can't max out your contributions, then aim to save more in 2019 than you did in 2018. These steps will free up cash for your retirement plan.
First, reduce one major expense from your budget and use your savings to fund your 401(k) or IRA. You'll often hear that cutting out your daily latte will help you retire, and while an extra $100 a month is nothing to turn your nose up at, to really make a dent in your savings goal, you need to think bigger.
This big change could mean selling a vehicle or downsizing to a smaller home. Both of these moves could put $300, $400, or even $500 back in your pocket each month, far more effective than tweaking your caffeine intake.
Next, consider getting a side job on top of your regular one, especially if you're unable or unwilling to cut back on spending in a meaningful way. The beauty of having a second gig is that the money you earn from it won't already be earmarked for other expenses, so you should have no problem sticking all of that additional income into your retirement plan.
Finally, make a point of saving any money you get that comes in the form of a bonus or raise. Again, since it's not cash you've been counting on, you won't miss it if you end up allocating it to retirement.
Save now; enjoy later
The better you're able to save in 2019, the more financial security you'll buy yourself in retirement. And while the idea of giving up dinners out, a vacation, or a nicer apartment might seem like a harsh price to pay for a milestone that's many years in the future, remember that in sacrificing today, you're helping your future self enjoy a much better existence down the line.
When you fund a 401(k) or IRA, you're really just paying yourself. And the more steps you take to maximize those accounts, the more comfortable you'll be at a time in your life when you'll think you've earned it.
