Making the Most of IRAs and Employer Tax-Deferred Retirement Savings
Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, firstname.lastname@example.org
The best way to make the most of IRAs and tax-deferred employer retirement savings plans (e.g., 401(k), 403(b), and 457 plans) is to contribute to them regularly and set aside as much money as you possibly can. The more money you save, the better, because a larger sum will grow tax-deferred, sometimes for decades. The result is a higher account balance at retirement compared to an equal amount of money saved in a taxable account (i.e., savings outside of a tax-deferred retirement savings plan).
An Individual Retirement Account (IRA) enables workers with earned income (i.e., salary from a job or net earnings from self-employment) to save and invest for retirement. IRAs are not an investment, per se, but, rather, a special classification for tax purposes. The actual investment will be in different types of securities such as stocks, bonds, certificates of deposit, or mutual funds. Arrangements to open an IRA account are made with a financial institution such as a brokerage firm, bank, credit union, or mutual fund company.
In the early 1980s, federal legislation created a tax-deductible IRA for anyone with earned income. Significant changes in 1986 established income limits for participants in an employer-sponsored retirement plan that eliminated the tax deductibility of IRA contributions for many people. Roth IRAs became available January 1, 1998. While not deductible, they offer federal income-tax-free growth of investment earnings. Roth IRAs were named after Senator William Roth (from Delaware) who led the effort to create them.
Federal tax law limits 2013 contributions to a traditional and/or Roth IRA to $5,500 for a worker with earned income ($6,500 for those who are age 50 or older before the end of the year). An additional $5,500 can also be saved for a worker’s spouse, regardless of whether or not the spouse is employed. In addition, spouses who are age 50 or older can contribute an additional $1,000 ($6,500 total) for a total of $13,000 of contributions if both individuals are age 50 and older.
If you don’t have this much money to contribute available, that’s okay. Simply save whatever you can, subject to minimum deposit amounts required by an IRA custodian (e.g., bank or mutual fund). Any savings is better than no savings! Minimum deposits required to set up an IRA vary with the financial institution and type of investment. For example, a bank may require a minimum of $500 to purchase a CD for an IRA and a mutual fund may require a $1,000 minimum deposit or higher. There are also a number of income limits with respect to IRAs. Most are indexed for inflation and change periodically as determined by tax law.
Below is a description of the IRA contribution limits for 2013:
• Roth IRAs are fully available to single filers whose adjusted gross income (AGI) is less than $112,000. No participation is allowed if your AGI is more than $127,000. Thus, the phase-out range, where contributions are limited in gradual steps as income increases, is between $112,000 and $127,000.
• Roth IRAs are fully available to joint filers whose AGI is less than $178,000. There is a phase-out range between $178,000 and $188,000. Married couples cannot contribute to a Roth IRA if their AGI is more than $188,000.
• People with earned income who are not in an employer-sponsored retirement plan, regardless of income level, may qualify for a tax deductible Traditional IRA. Another group of taxpayers who can deduct a Traditional IRA contribution in full are those with an employer-sponsored plan who have incomes under $59,000 (single) and $95,000 (married couples filing jointly). The phase-out ranges for singles and couples are $59,000 to $69,000 and $95,000 to $115,000, respectively. Above these amounts, taxpayers can make a non-deductible, tax-deferred Traditional IRA contribution.
• A working spouse who is not covered by an employer-sponsored plan may have a fully deductible Traditional IRA, even if the other spouse is in an employer-sponsored plan, if the household AGI is less than $178,000. The phase-out range for deductible contributions is from $178,000 to $188,000.
Retirement savings contribution limits are even more generous for tax-deferred employer retirement savings plans (e.g., 401(k), 403(b), and 457 plans) than for IRAs. In 2013, workers can contribute up to $17,500 (23,000 for those who are age 50 or older before the end of the year). Again, however, don’t let these big numbers scare you. Any savings is better than nothing. The required minimum can often be as low as 1% of a worker’s pay or a low dollar amount such as $10. Even relatively small savings amounts can grow significantly over time.
The trend in employee benefits today is for an increasing number of employers to offer defined contribution plans, such as 401(k)s, where employees voluntarily reduce their salary by a specific dollar amount (generally, a percentage of their gross income) which is set aside for retirement. When it’s time to retire, workers have available the amount that they have saved, plus or minus the earnings (or losses) on their selected investments. The account balance is portable, which means money in the plan can be taken out when employees leave a job and rolled over into an IRA or new employer’s retirement savings plan.
Unlike IRAs, the “menu” of available investment options for employer retirement savings plans is limited to securities selected by the employer or the employer’s retirement plan provider. For this reason, investment advisors often recommend balancing investments that are selected within tax-deferred plans with different types of investments that are held in IRAs and/or taxable accounts.
Employer retirement savings plans offer the following four benefits to workers, regardless of income:
• Before-Tax (Pre-Tax) Contributions– This means that the portion (e.g., 6%) of a worker’s salary that is saved is not subject to federal income taxes until it is withdrawn, typically at retirement. Workers do not have to include the amount of plan contributions on their tax return for federal income taxes.
• Tax-Deferred Earnings– Like retirement plan contributions, the earnings on investments within a retirement savings plan are not taxed until withdrawal This means that investments grow faster than they would have otherwise in a taxable account where taxes on account earnings are due each year.
• Automatic Deposits– Retirement plan contributions are made through payroll deduction, which makes it easy and convenient to save. Automated contributions also take the emotion out of investing because deposits are made regardless of market conditions.
• Employer Matching- Many employers, especially for-profit corporations, match their employees’ retirement plan savings by a specific percentage of employee contributions. A common employer match is 50% of employee contributions up to 6% of their gross income (e.g., $1,200 if a worker earning $40,000 contributes 6% of pay ($2,400), for a total of $3,600 of savings). This is “free money” that should not be left on the table. In addition, employer matching can help cushion the shock of investment losses. A 50% match is equivalent to a guaranteed 50% investment return.
Make the most of tax-deferred investments by saving as much as you can and assembling a well-diversified portfolio that includes different types of asset classes (e.g., stock, fixed-income, and cash equivalents). Want to know more about investments available for retirement savings? For additional information, visit the eXtension Investing For Your Future course at http://www.extension.org/pages/Investing_for_Your_Future and click on Unit 7.