How to Save?

One question that came up over and over was how to decide between tax-deferred savings (IRA, 401(k), SEP) or tax-advantaged savings (Roth 401(k)/Roth IRA).  Or why save in a retirement account at all, when you have prepayment penalties, and the capital gains rate is lower than the tax rate that you'll pay on a traditional IRA or 401(k) when you withdraw the funds?

The answer is that tax-advantaged (deferred or otherwise) is always better.  Choosing between tax advantaged accounts is more complicated.  To provide a very simple model, here is what the decision to invest looks like in a world where income tax rates are constant at 25%, we assume you plunk your money into a single stock that grows a steady 5% every year, and the long-term capital gains rate is 15%:

However, the real world is a bit more complicated than this.  Your tax rate does not stay the same over your entire life.  So you have to ask yourself: is my tax rate likely to be higher or lower when I retire than it is now?  Will I be taking out as much money in retirement as I'm currently earning?  Will I be living in a lower-tax jurisdiction?

If you're an entry level worker, or planning to retire to California, your tax rate in retirement may well be higher than your current tax rate.  Then you will want to skew your savings towards a Roth IRA: pay taxes at a low rate now, and no taxes at all when you retire.

On the other hand, if you're in a higher tax bracket than you expect to retire in, or living in New York City, then you want to prioritize tax deferral: save on taxes now, pay at a lower rate later.

However.  You need to factor in probable policy changes.

The government is hungry for money.  It's going to have to get that money somewhere.  Where will that money come from?

If you think it's coming in the form of a sales tax or VAT, there is no retirement planning that will get around this, so you can safely ignore it.

If you think it will come in the form of higher broad-based income tax rates, then you should take the same strategy as an entry level worker: assume your taxes will be higher later, and tilt your savings towards vehicles that are tax-free in retirement.

If you think that the government is going to be tempted to tap into Roth IRAs, maybe with a special surtax for "rich" people who've saved a lot, maybe by getting rid of Roth deductibility altogether for people with high retirement incomes or sizeable Roth accounts, then you should act like our proverbial New York hedge fund manager: prioritize traditional IRAs and 401(k)s.

My personal opinion is that the government is probably going to end up with a mix of all three: higher income tax rates, a VAT, and at least a partial rollback of the Roth tax-free status.  But I can't prove that; it's just my hunch.  You'll have to make up your own mind about what the future is likely to hold.

There's are a few other considerations, however, which is which vehicles are available to you, and how much each vehicle lets you save.

Most people cannot save enough money for retirement in a Roth IRA alone, so that shouldn't be your only vehicle.

However, a Roth IRA lets you save more than a traditional IRA.  In the example above, I assumed you were going to save $1,000 worth of your paycheck no matter what, which translates into a $750 investment in your Roth IRA.  But actually, the contribution limit on a Roth IRA is the same as a regular IRA: $5,000.  So while you're saving $5,000 worth of your paycheck in a traditional IRA, you're saving more like $6,500 in a Roth.  If you want and need to save more, but you're bumping up against the contribution limits, use the Roth.

By the same logic, most people should be using their 401(k)--it's the only vehicle which lets most people save enough.  You should especially be using your 401(k) if there is an employer match.

The other consideration is: what are you eligible for?  You can only use a 401(k) if your employer offers one.

There are limits on who can contribute to an IRA.  For a Roth IRA, the amount you can contribute starts to phase out when your Adjusted Gross Income hits $107,000, and phases out entirely at $122,000.  For couples, those figures are $169,000 and $179,000.

For traditional IRAs, it is a bit more complicated and depends on whether you or a spouse is covered by a retirement plan at work.  Your accountant or tax software can help you figure out if you're eligible.

If you have self-employment income, you can save in an SEP-IRA, but only up to a percentage of your self-employment income (you cannot start a business that makes $500 a year and use an SEP to save $10,000.)  Again, if you're in a situation where this is an issue, you probably need to talk to a tax professional.

The upshot is that there is no "one right answer" for how to use tax advantaged savings--except that you should be using them if you possibly can.