Retirement Step 4: Choose the Right Account

Retirement Step 4: Choose the Right Account

Repeat after us: "Retirement savings are for retirement." Again. "Retirement savings are for retirement."

Why this mantra? Simple: The best place to put your savings is in tax-advantaged accounts. As with all things IRS-related, you'll pay a penalty if you want to get your mitts on the moola before the golden age of retirement. So, once again: "Retirement savings are for retirement."

Now that you've promised to put your money away for the long term, where should it go? You have many options when it comes to retirement accounts. We've pulled out the most important types and developed a general pecking order of where you should deposit your savings:

  • Employer plan with a match

  • Roth IRA

  • Employer plan without a match

  • Traditional IRA

  • Taxable investment

  • Annuity

Here's a closer look at each and the general Foolish order of things:

1. Employer plan with a match
If your employer matches your contributions to the company's defined contribution plan -- e.g., 401(k) or 403(b) -- this should be the first place to devote every dollar that you can afford to lock away for the long term. Why? You're staring at free money, and you shouldn't just stare at free money -- you should take it.

Other advantages of an employer-sponsored plan:

  • Tax deduction: The money you contribute to the employer plan is not included in your income for tax purposes.

  • Tax deferral: You don't pay taxes until you retire. That leaves more of your money to grow through the years.

  • Automatic investment: The money is transferred directly from your paycheck to your account. No checks to write, no monthly reminders, no paper cuts to the tongue while sealing the envelope.

The contribution limits vary from plan to plan, but generally, the limits are:

  • 2012: $17,000

  • 2013: $17,500

Thereafter, the limit will increase in $500 increments whenever the cumulative effects of inflation indicate such an increase is needed.

In addition to the normal contribution limits outlined above, those over the age of 50 can make an additional "catch-up" contribution in the following amounts:

  • 2012: $5,500

  • 2013: $5,500

Again, the "catch-up" limit will subsequently increase in $500 increments whenever the cumulative effects of inflation indicate such an increase is needed.

While your employer's plan should be the first stop for your retirement dollars, it shouldn't be the only one, since most employers only provide matching funds for contributions that total a set percentage of your salary. Check your plan. For instance, if the employer provides a match only for the first $3,000 that you contribute annually, but you're contributing $5,000, that unmatched $2,000 might well be put to even better use -- namely, a...

2. Roth IRA
The next place to turn after you've taken full advantage of the company match (i.e., free money) is a Roth IRA, as long as you qualify. (Your ability to contribute to a Roth begins to phase out at a modified adjusted gross income of $110,000 for singles and $173,000 for joint filers in 2012, reaching the ineligible stage at $125,000 and $183,000, respectively. For 2013, the lower limits are $112,000 for singles and $178,000 for joint filers, and the upper limits are $127,000 and $188,000 respectively.)

Why a Roth?

  • Tax-free growth: While you won't get a tax deduction on contributions to a Roth IRA, you'll never have to pay taxes on the earnings when you begin withdrawals (assuming you follow the rules).

  • More control: If you open your account with a discount broker, you can purchase individual stocks, bonds, and any index investment offered through that broker. This is an advantage over the limited selection offered by most employer-sponsored plans.

  • No mandatory distributions: With employer-sponsored plans and traditional IRAs, you must begin withdrawing funds by April of the year following the year in which you reach age 70 1/2, even if you don't need the money. Not so with a Roth. If you don't need the money, it can keep growing on its merry, tax-free way.

The contribution limit for a Roth (and traditional IRA as well) is $5,000 for 2012 and $5,500 in 2013. Thereafter, the $5,000 maximum allowable contribution will be indexed to inflation in $500 increments.

3. Employer plan (again!)
We still like defined contribution plans (like 401(k)s and 403(b)s) for your retirement savings, even after you've reached the matching limit. The money that you contribute to the plan comes regularly out of your paycheck, without you having to do anything at all, and you're getting that tax deduction by contributing pre-tax money. Again, the contribution limits vary from plan to plan, but generally, the limits are $17,000 for 2012 and $17,500 for 2013, and an amount indexed to inflation after that.

However, the investment options in your plan might not be too great. If you're staring at a bunch of underperforming managed mutual funds as your only choices, you might want your money going to better accounts. Each month, our Rule Your Retirement service takes a detailed look at what qualifies as a "good" investment for the long term.

4. Traditional IRA
If your income level is too high for you to start or to continue contributing to a Roth IRA, you can nonetheless make a contribution to a traditional IRA. The annual contribution limits are the same as for the Roth, and those limits apply to total annual IRA contributions; in other words, you can't contribute $5,000 to a Roth and $5,000 to a traditional IRA (at least until contribution limits reach $10,000 a year).

A traditional IRA grows tax-deferred and is taxed as ordinary income upon withdrawal. Plus, contributions are tax-deductible if 1) your employer doesn't offer a retirement plan, or 2) your adjusted gross income is below a certain level. Those levels change every year, so check with the IRS. For 2012, for example, the limit is $58,000 (gradually phased out until $68,000) for single tax filers or $92,000 (gradually phased out until $112,000) for married filers. The corresponding limits for 2013 are $59,000 and $69,000 for singles and $95,000 and $115,000 for joint filers.

5. Taxable investments
After you've maxed out the tax-advantaged vehicles at your disposal, only then should you put your retirement savings dollars into taxable accounts. However, if you don't like the investment options available in your employer-provided plan, then you might move taxable investments up higher on this list, ahead of your unmatched defined contribution plan.

6. Annuities
For most people, annuities are a last-resort investment. They are too expensive, offer mediocre insurance coverage, restrict the owner's investment choices, and lack liquidity. Because of the large fees (read: commissions for your broker) associated with annuities, they are a favorite of brokers and planners. It's not uncommon for Rule Your Retirement members to regale us with annuity pitches offering outrageous claims. When it comes to a legitimate pitch, annuities are most suitable for investors who:

  • Have contributed the maximum to their defined-contribution plans and IRAs and desire further tax deferral on investment gains.

  • Prefer investing in mutual funds, as opposed to individual securities.

  • Will keep the annuity for at least 15 to 20 years.

  • Are in a 25% or higher income tax bracket today, but expect to be in a lower income tax bracket in retirement.

  • Don't need the annuity proceeds prior to age 59 1/2.

  • Are unconcerned that heirs must pay ordinary income taxes on any appreciation.

  • Desire a "guaranteed" income for life in retirement.

How much should go where?
If you've happened to catch any commercials for the big banks and brokerage firms, you may have noticed that "asset allocation" is a hot selling point. Each sepia-toned sales pitch claims that the firm knows that elusive formula that will put all of your dollars in the exact right place at the right time. A healthy percentage of those dollars will be allocated right in your planner's pocket.

We prefer a simpler way of thinking. Let's start with the conventional wisdom of yore: Typically, the rule of asset allocation was to subtract your age from 100, and devote that portion to stocks. Therefore, a 50-year-old would have 50% of her portfolio devoted to stocks. A 70-year-old should only have 30% devoted to stocks. Then people started living longer, and the number to subtract from became 110. Perhaps there is some broad-stroke sense to that, but in reality, retirees must determine an allocation that provides peace of mind while still generating the income and portfolio growth required for a long and healthy life.

Generally speaking, here are the Fool's rules for asset allocation:

  1. Any money you need in the next year should be in cash.

  2. Any money you need in the next two to five (or even seven to 10, depending on your risk tolerance) years should be in a safe fixed-income investment, such as certificates of deposit or bonds.

  3. Any money you don't need in the next five to 10 years is a candidate for the stock market.

Such an allocation will make sure the cash you need today is ready to be spent, the money you need in the few years will be safe from a stock market crash, and the money you need several years hence will be growing enough to beat inflation. (We cover asset allocation here in the retirement collection, and in more depth on our Rule Your Retirement website. Check it out for the next 30 days for free to see how a balanced strategy can help grow and preserve your nest egg.)

As you can tell, we love tax-advantaged retirement accounts. However, keep this in mind: Money that you are saving for retirement should be money that you definitely won't touch until your retirement. Sure, you can get money out of a 401(k) or IRA before your retirement age if you absolutely have to, but there's generally a penalty -- and some taxes to boot -- attached to doing so. Again, the best thing to do is to repeat after us: "Retirement savings are for retirement."

Now, on to Step 5: Take stock.

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