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Which Retirement Account is Best for Savers

The government really wants you to save for retirement. Lack of retirement savings is a serious problem in the US and the most recent 2022 Survey of Consumer Finances states that the median retirement savings balance for those age 65-74 is $200,000. How much will that generate in retirement income? A good way to tell is to see what an immediate annuity would pay you for life. As of today, for a 66 year old male, living in NJ, that $200,000 will generate $1,398 per month in lifetime income. An immediate annuity works like a pension with periodic payments made for life. I am not recommending the median saver buy one for a lot of reasons, but it’s useful to use an annuity to understand the amount income you can generate with a given lump sum.

$1,398 per month is $16,776 per year and if you add some Social Security, maybe this saver will have an income somewhere between $37,000 and $45,000 per year. This is the picture for many retired Americans, but if you are still working, you need to think about creating a larger retirement nest egg to ensure you will have the retirement you want.

Types of Retirement Accounts

We’ve established that you want to save more for retirement, so what kind of account should you use? There are two general types of tax-advantaged retirement accounts available: Tax-deferred, and Tax-exempt.

Tax Deferred Accounts

Tax-deferred accounts include some that are available through your employer, such as traditional 401(k), 403(b), Simple IRA, Simple 401(k), and SEP IRA accounts. You also may have access to a traditional IRA if you make less certain limits or if your employer does not provide a retirement account. Tax-deferred accounts give you a tax deduction when you contribute to them, lowering your current taxes. Later when you withdraw during retirement, you will have to pay taxes. So you have deferred your taxes to a later date, when (maybe) your income is lower, so your tax rate might be lower.

Tax Exempt Accounts

Tax-exempt accounts are usually called ROTH accounts. You may have access to a ROTH 401(k) or 403(b) through your employer. With these accounts, you are making contributions with money that has already been taxed. There is no tax deduction when you contribute. But any gains in the account can be distributed to you tax-free when you retire. This can provide a significant benefit to you. If you contribute $7000 a year to a ROTH IRA over 30 years, you will have contributed $210,000. If you were able to earn 5% each year on your money, your account total would be $465,072. Your gain would be $255,072 and that gain would be totally tax-free.

Where Should You Put Your Savings?

The answer to this question may be different for different people. The question to answer is whether the tax you save by contributing to a tax deferred account now is going to be more or less than the tax you might save on the gains later by contributing to a tax-exempt ROTH account. The answer might depend on what tax bracket you are in or if you are close to a breakpoint in the tax code that causes a surcharge or removes your eligibility for a tax benefit. The answer also depends on what tax bracket you are in now versus what tax bracket you might be in when you retire. Also are you living in a state where you have to pay income taxes now and do you plan to retire to a state where retirement plan distributions are tax-free?

Still, there are some rules of thumb to help you make the decision. If you are young and just starting out, it makes a lot of sense to use the ROTH tax-exempt accounts. You have a lot of time to generate gains and your lower income now probably means you are in a lower tax bracket now than later. Another factor is that tax rates were lowered with the Tax Cuts and Jobs Act in 2017. Most of the provisions of this act expire 12/31/2025, so that might be another reason why paying taxes now is better than paying taxes after 2025 and you should use the ROTH accounts.

On the other hand, perhaps you have kids in college and are taking advantage of the American Opportunity Tax Credit. The maximum credit is $2500 per child and it starts to phase out when your income goes above $80,000 (single) or $160,000 (joint). If you can lower you income enough by contributing to a traditional IRA or 401(k) to get under these limits, you should do so. In that case, you would not want to use the ROTH accounts.

The Most Important Thing

The most important thing is to save for retirement. The account you choose is far less important than consistently saving through your life. How much should you save? Assuming you start working at 25 and stop working at 65, you have 40 years. If you can make 6% on your money each year by investing it and you save the same amount each year, to amass $1,500,000 by age 65, you will need to save $9692 each year. Of course, you need to adjust your contributions for inflation. Your earnings will go up with inflation, so this is easy. If you start saving later, you will have to save more. If you only save 20 years, you will need to save over $40,000 each year to end up with $1,500,000.

Figuring out which account to use and how much to save is something a Certified Financial Planner™ can do for you. It is something I do with clients all the time. It’s just another reason why you should work with a planner from Cereus Financial Advisors. We would be happy to discuss questions like this with you at any time.

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