Preparing for Retirement
Part 2: Which Account?

This is a question that has wasted a lot of ink and a lot of keystrokes for the last 50 years. That’s because every person’s situation is different. I hope the following logic helps you.

First, let me describe the difference between a retirement account instrument/bucket and an investment. An investment might be a stock, a bond, a real estate asset like a house, or a mutual fund that invests in stocks and bonds. We will tackle investment allocation in the next article. A retirement account instrument is a bucket inside of which you put investments. Think of a stock like an apple and bond like an orange. A mutual fund is like a bowl of fruit salad. You can put apples, oranges, and fruit salad into bucket A (Roth IRA) and you can put apples, oranges, and fruit salad into bucket B (Traditional IRA). Make sense?

So how do you choose the right bucket for you?

Please remember that you can have multiple buckets. You might invest in a Roth IRA, Traditional IRA, 401(k), and 403(b) all in the same year if you want!

Here’s the advantages and disadvantages of each

Roth IRA

Advantages

Your money grows tax free and can be withdrawn starting at age 59 ½ with no penalty.

Disadvantages

You have to put after-tax money into your account. You are limited in how much you can save, and there are income limits.

Contributions limited to $6,000 per year ($7,000 if 50 or older).

Traditional IRA

Advantages

Money you contribute reduces your taxable income the year you contribute. Your money grows tax free and can be withdrawn at age 59 ½ with no penalty. 

Disadvantages

When you withdraw your funds, withdrawals are taxed like ordinary income.

Withdrawals before age 50 ½ incur a 10% penalty AND are taxes as ordinary income.

Contributions limited to $6,000 per year ($7,000 if 50 or older).

Roth 401(k)

Advantages

Same as Roth IRA.

You can invest more than a Roth IRA, up to $19,500 in 2021, $26,000 if 50 or older.

No meaningful income limits like a Roth IRA.

Disadvantages

Same as Roth IRA, you have to put after-tax money into your account.

401(k)

Advantages

Same advantages as a Traditional IRA, AND you can invest more than an IRA, up to $19,500 in 2021, $26,000 if 50 or older.

No meaningful income limits like an IRA.

If you retire between age 55 and 59 ½ you may be able to access funds from the employer 401(k) from which you retire.

Disadvantages

Same as a traditional IRA, when you withdraw your funds, withdrawals are taxed like ordinary income.

Withdrawals before age 50 ½ incur a 10% penalty AND are taxes as ordinary income. 

Withdrawing funds before 59 ½ may be prohibited by your employer.

403(b)

Advantages

Very similar to a 401(k) except provided by many non-profit employers including churches. A 403(b)(9) allows withdrawals after age 59 ½ to be designated as housing allowance, essentially shielding funds from EVER being taxed.

Disadvantages

If your spouse inherits your 403(b)(9) when you die, they will not be able to designate withdrawals as housing allowance unless they are also licensed/ordained.

“That’s a lot of information, now where do I start?!”

Trust me, it’s a lot simpler than it looks, at least to get started. 

#1 Start by saving in the retirement savings bucket that has employer matching.

If your employer matches ANY amount of your contribution, start there to max out the contribution. Why would someone would NOT take the free money their employer is offering. Even if you have a 403(b)(9) at your church (the best retirement savings option), but your spouse gets a match on their retirement, save in the matched retirement account first!

#2 Save in a 403(b)(9) if it’s available. A 403(b)(9) is almost too good to be true:

• All the advantages of a 401(k) such as

  • Any money you contribute reduces your taxable income in the year you contribute. 

  • High contribution limits.

• All the advantages of a Roth IRA/Roth 401(k)

  • Your money grows tax free and can be withdrawn after 59 ½ tax-free if you take it as housing allowance.

#3: If your income is less than $33,000 Single, $49,500 Head of Household, or $66,000 Married Filing Jointly, save in a 401(k) or 403(b) to maximize the Saver’s Credit.

#4: Save in the instrument that is best for your tax situation.

That may not seem very helpful. Touche. Here’s something maybe more helpful.

1. If you are in the 24% or higher tax bracket, prioritize lowering you tax bill NOW by saving in pre-tax instruments like 403(b), 401(k) and traditional IRA.

2. If you’re in the 0%, 10%, or 12% tax bracket, you hope to be in a higher tax bracket in retirement so save in post-tax instruments like Roth IRA and Roth 401(k).

3. If you’re in the 22% tax bracket, consider contributing to both Roth and Traditional/Pre-Tax instruments. This manages the risk of tax rates moving up or down in the future.

The short version of why I recommend this rule of thumb: Most people have a higher income income during their working years than in their retirement years. Assuming tax rates don’t change, and they definitely will, one way or the other, you want to move taxable income from your working years to your retirement years.

In 2021, taxable income is taxed at 12% up to $54,200 for married couples. When you add on the standard deduction of $25,100, you can earn $79,300 and still stay in the 12% tax bracket. If everyone reading this could have an income of $79,300 in retirement, I would be ecstatic.

One final note: Invest Automatically!

If you can save through a payroll deduction, that is ideal. Investing in a consistent way is extremely important and most of us budget off what hits our checking account. If you don’t have the option of investing in an employer sponsored retirement plan, consider having a portion of your paycheck sent directly to the investment company. If none of those are options, have your retirement funds drafted directly from your checking account by your retirement account custodian.