Where to Save for Retirement

If you’ve got access to IRAs, 401(k)s, and Roth accounts then where is the best place to put your money? It’s probably not immediately clear from the pros and cons, but there’s a straight forward method to ensure you’re getting the most from your accounts.

In Step 4 of the Financial Blueprint we start saving 15% of our pre-tax income for retirement. This may sound high to some people and it will probably feel high if you’re not doing these steps in order. For those of you who cut out retirement savings (like you were supposed to) to work these steps in the optimum order, this is where you will catch up and blow by those who tried to do too much at once.

So the first step is easy. Figure out how much you need to be saving.

• Take 15% of your pre-tax income (what’s on your W-2) and divide it by 12. That’s how much you need to save each month.

Get the Full Match

Now you need to figure out which accounts to invest in. If your employer’s 401(k) plan offers a match incentive then you don’t want to pass that up. For example, they may offer to contribute 50 cents for every dollar you invest up to 6 percent of your income (“match 50% up to 3%” in their jargon). That means that if your take home pay was $5,000 a month, and you invested 6% of that into your 401(k) ($300), your employer would kick in $150 (3%) as a match.

If your employer doesn’t offer a 401(k) or doesn’t match it then just skip this part.

Get the Tax Savings

Next comes my favorite accounts: Roth IRAs! If you invest $416 a month ($5,000 a year) for 35 years for retirement in a Roth account earning between 8% and 10% interest then you’ll have over a million dollars. Because you saved it in a Roth account however all the taxes have been paid. It’s all yours to keep! How great is that! That’s why the next place to save for retirement is in a Roth IRA account.

• If you’re taking advantage of a 401(k) plan from the first step, then figure out how much more money you need to invest to get to the full 15% of your pre-tax income.
• Now use your Roth IRA to save as much as you can! You can only contribute $5,000 annually (as of 2010) to these accounts (if you’re married you can each have your own Roth IRA so that’s $5,000 each).

Top it Off

If you’ve gone through the 401(k) match (or skipped it), maxed out your Roth IRA(s), and still need someplace to invest to get to the full 15% savings goal, then go back to the 401(k). Because of the higher contribution limits on a 401(k) most people can easily finish their 15% pre-tax savings here.

Method to the Madness

As I discussed in the Retirement Account Basics post, an IRA is a better place to save for retirement then a 401(k) because of the control. Your investment choices are only limited by your broker which means you can choose from the best funds available. 401(k)s have a very limited number of funds you can choose from and they frequently have fees you would really like to avoid. If you’re taking advantage of a free match from your company then that more then offsets these negatives, but otherwise we want to make the most of the tax-free Roth accounts first.

(Photo Credit)

Related posts:

1. Retirement Account Basics
2. When To Invest