By Stuart Ritter on February 27, 2012
Investing for a secure retirement may be your most important financial goal.
The first step is to make sure you're saving enough in tax-advantaged retirement accounts. Roth IRAs and Roth contributions within a 401(k) may be the best options for many investors. You also should take full advantage of employer matching contributions to a workplace plan. Determining how much to contribute to each type—and in what order—will maximize the benefits available to you.
Begin by calculating approximately how much annual income you'll need in retirement. As a rule of thumb, you might plan to replace 75% of your preretirement income—approximately 50% from investments and the other 25% from Social Security, employer pensions, or part-time work.
You'll need to figure out the right savings rate for 401(k) and IRA contributions in order to help you attain your goal. Most investors should save at least 15% of their annual gross income, including any employer matching contributions, in retirement accounts. If, for example, you receive a 3% match, you only need to contribute 12% to reach your savings target.
Once you have determined how much to set aside in annual retirement savings, map out a strategy for your contribution sequence.
1. Do Roth contributions make sense for you?
Roth contributions may provide the most flexibility for you—and they may be your best option in retirement. Withdrawal of any earnings from a Roth IRA made after you reach the age of 59½ are not subject to federal income tax if your account has been open for five years or more, and contributions can be withdrawn at any time penalty- and tax-free. Additionally, there are no required minimum distributions (RMDs) from a Roth IRA for the account owner, which gives you the flexibility to determine when to take distributions—and, in fact, whether you want to take them at all. You must, however, take RMDs from a Roth account within your employer-sponsored retirement plan. Investors who are both over age 50 and expecting their marginal tax brackets to decline significantly in retirement may want to consider contributions to a Traditional IRA.
2. Does your employer offer a Roth contribution option within your 401(k)?
If so, it may be in your best interest to contribute the full 15% to your plan, regardless of whether the plan offers a company match. There are no income limitations for Roth contributions to your account in 401(k) plans. If your employer doesn't offer the option of contributing to a Roth account, contribute enough to your 401(k) plan on a pretax basis to earn the full company match, if available. Then consider whether you're eligible to contribute to a Roth IRA.
3. Are you eligible to contribute to a Roth IRA?
For tax year 2011, you can fully fund a Roth IRA if your modified adjusted gross income (MAGI) is under $107,000 as a single taxpayer or under $169,000 if you are married and file a joint return ($110,000 and $173,000, respectively, for 2012).
You may want to contribute the maximum annual contribution to a Roth IRA and then contribute additional pretax savings to your traditional workplace plan, if your employer plan doesn't offer a match or a Roth 401(k) contribution option.
A Traditional IRA may be an appropriate option for you if you are both over age 50 and expecting your marginal tax bracket to decline significantly in retirement; you have contributed the maximum to your 401(k) and still want to contribute more to retirement (and you are ineligible to contribute to a Roth IRA); you don't have a
401(k) to contribute to, and Roth contributions don't make sense for your personal situation. Consult with a financial advisor to discuss your personal circumstances.
The tax-advantaged benefits of employer-sponsored retirement plans and IRAs can provide you with a significant opportunity to maximize the amount you save for your later years. An effective way to ensure that your IRA is fully funded and the money you intend to contribute won't be diverted from your retirement savings is to sign up for an automatic asset builder program that withdraws periodic contributions from your bank account throughout the year.
To learn more about T. Rowe Price's IRA Automax service, visit troweprice.com/automax.
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T. Rowe Price (including T. Rowe Price Group, Inc., and its affiliates) and its associates do not provide legal or tax advice. Any tax-related discussion contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i.) avoiding any tax penalties or (ii.) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this article.