Can you contribute more to your employer's 403(b) or 401(k)? And if you can, should you? Or would it be better to sink those extra dollars into an IRA? Making the right decision can have a big impact on your eventual retirement income. If your employer's plan has high fees, you can do a lot better by putting those dollars to work in an IRA at an investment firm that has low fees.
How much better? Suppose your employer's plan charges an extra 1% in fees each year (as many do), causing your pre-fee returns of 6% to get reduced to 5%. Over 10 years, if you contributed your dollars every year to a low-fee IRA, instead of your employer's plan, they would grow to a total that's nearly 5% bigger. And over 20 years, your dollars would grow 11% more.*
If that sounds enticing, here's how to proceed. First, you need to know your target, the number of dollars you need to save each year to meet your retirement goal. Advisers often recommend 10-15% of your pre-tax income. Or you can use our retirement calculator to get a more precise estimate. Next, subtract the all the following types of contributions that go to your 401(k) or 403(b):
How much better? Suppose your employer's plan charges an extra 1% in fees each year (as many do), causing your pre-fee returns of 6% to get reduced to 5%. Over 10 years, if you contributed your dollars every year to a low-fee IRA, instead of your employer's plan, they would grow to a total that's nearly 5% bigger. And over 20 years, your dollars would grow 11% more.*
If that sounds enticing, here's how to proceed. First, you need to know your target, the number of dollars you need to save each year to meet your retirement goal. Advisers often recommend 10-15% of your pre-tax income. Or you can use our retirement calculator to get a more precise estimate. Next, subtract the all the following types of contributions that go to your 401(k) or 403(b):
- What your employer contributes, if they do.
- What your employer requires you to contribute, if you have mandatory contributions.
- The total of your contribution plus the employer's match, if the plan includes an employer-match.
- Know your target. One rule of thumb is to save 10-15% of your income toward retirement. Well, 10-15% of what, exactly? (Sounds simpler than it is.) The point is to save 10-15% of your post-tax income in a taxable account or a Roth account, or save 10-15% of your pre-tax income in a non-Roth IRA, 401(k), 403(b) or other pre-tax account. The dollar-amount is different if it's pre-tax or post-tax. (Keep that in mind as we proceed.) If possible, try to set a target more precise than the 10-15% guideline, especially if you are behind-schedule in saving for retirement. For this, try our retirement calculator. Use different settings on the calculator to find out how many dollars you need to save per year to have a reasonable income after you retire.
- Find out what your employer contributes. Clearly, this applies only if you are fortunate enough to have an employer who contributes to your retirement. The most common forms are a non-profit or educational employer's direct contribution to a 401(a) pension or 403(b) savings account in your name. Find the annual (12-month) total in dollars, and subtract it from the yearly target you set in step 1.
- Maximize any employer-match. If your employer offers a 401(k) or 403(b) match, take it. Max it out. For example, if you get a 50% match on the first 3% you contribute to your own retirement account, you would do two things. First, double-check to be sure you are actually contributing your 3%. Second, calculate the annual dollars at 4.5% of your pre-tax income (your contribution plus the employer's match), and subtract that from your target. Of course, if your employer's match works on different percentages, use those.
- Add your mandatory contributions. Are you required to contribute a portion of your pay to your employer's pension or retirement plan? If so, convert it to annual dollars, and subtract that amount from your annual target.
- Calculate your voluntary contributions. Time to stop and check. What's left at this point? It's the amount you need to contribute voluntarily. Hold on! Have you already met your target? Then you are doing very nicely indeed, and you may stop right here (though I would encourage you to continue and save even more). If you've not met your target, definitely read on.
- Get your modified AGI and your tax-rate. This is where it gets ugly. Because we have to invoke the IRS. Sorry, it's unavoidable. Go get your tax return, and find the line with your Adjusted Gross Income. Also get your tax-rate. I'm going to assume it's 25% in the following steps, but your rate may be different. And one more thing. If you deducted student-loan interest or tuition expenses on your tax return, you will have to add them back to get your modified AGI. Same goes for adoption benefits from your employer, foreign earned income or housing, some savings bond interest, and domestic production activities. Official details are here.
- Estimate a traditional IRA contribution.** The IRS says you can contribute to a traditional IRA and your employer's plan and get a tax-deduction for both if you can answer yes to one of the following; (a) Your modified AGI is $96,000 or less, and you are married filing jointly or a qualified widow(er). (b) Your modified AGI is $60,000 or less, and you are filing as single or head of household. (c) Your modifed AGI is $10,000 or less, and you are married, filing separately. You made it this far? Yes! Write down $5500 if you are under 50 or $6500 if you are 50 or older. We'll use that figure after checking whether you could instead contribute to a Roth IRA.
- Estimate a Roth IRA contribution. The calculation for this is a bit trick, but definitely worth doing. You might qualify for a Roth IRA even if your AGI disqualified you for a tax-deductible traditional IRA. First, see whether you can answer yes to one of these questions: (a) Is your modified AGI under $188,000 and you are married filing jointly or a qualified window(er)? (b) Is your modified AGI under $127,000 and you are single, head of household, or married but filing separately from a spouse with whom you did not live for the full year? (c) Is your modified AGI under $10,000 and you are married filing separately from a spouse with whom you lived for some portion of the year? Affirmative for one of these? Good. Next comes a bit of math. We'll use the IRS limits that typically apply in 2014 and 2015. Write down $5500 if you are under 50; $6500 if you are 50 or older. Convert it to a pre-tax equivalent by dividing that number by one minus your tax-rate. For example, if your tax rate is 25% (0.25), you divide by 0.75. That means $5500 becomes $7333 and $6500 becomes $8666. Use your tax rate, if it's different.
- Apply an IRA contribution to your annual target. If step 8 said you qualify for a Roth IRA, subtract the number you calculated in that step from the amount remaining at step 5. If you qualify for both a tax-deductible traditional IRA and a Roth IRA, pick one or the other, not both. My advice: take the Roth if you can. Some advisers discourage a Roth IRA if your current tax-rate is high, but in that case, the modified AGI limit might have disqualified you, so the point may be moot. Now subtract your IRA contribution from the target amount that remained at step 5. In the Roth case, you be subtracting the pre-tax equivalent from your remaining target, even though your actual Roth contribution is lower. For the example of a 25% tax-rate, you subtract $6333 or $8666, but your actual Roth contribution would be $5500 or $6500. That's because your target amount is in pre-tax dollars. It's simpler for a tax-deductible traditional IRA because there's just one number.
- Also ... maybe ... contribute voluntarily to your 401(k) or 403(b). This is the last step. Promise! You've contributed to the IRA, right, possibly up to the maximum the IRS allows? But even after all that, have you still not met your annual target? Oh, no. Well then, contribute more to your employer's plan. Just be aware of the tax-deductible limit. Your employer will tell you the maximum amount you can contribute in a year; the full IRS details are here. You have to reduce that number by the amount you contributed to a traditional IRA in step 9. There's no reduction if you contributed to a Roth, which is a good reason for preferring it.
None of the information here should be taken as advice or solicitation to buy a particular fund, security, product, annuity, or type of insurance. You are responsible for your investment decisions, and should read the prospectus and disclosures for a security before investing. Investments have risks; you may lose money. Able to Pay LLC is not a tax advisor. Please consult your tax advisor, and read our full disclosures and Fiduciary Oath.
* Since you invested more each year, your savings have been growing, on average, for about 10 of the 20 years - some longer, some shorter - so the cumulative gain is about half of 1% per year, plus some compound interest.
** If you are not covered by an employer's 401(k) or 403(b) plan, but your spouse is, your spouse should be reading this, not you. Be aware that for you, there's a different wrinkle. You can't claim a tax-deductible contribution to an IRA if your modified AGI is over $181,000, either on a joint return or an individual return.
** If you are not covered by an employer's 401(k) or 403(b) plan, but your spouse is, your spouse should be reading this, not you. Be aware that for you, there's a different wrinkle. You can't claim a tax-deductible contribution to an IRA if your modified AGI is over $181,000, either on a joint return or an individual return.
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