How to Save for Retirement

Employers are not required by law to offer matching contributions in their retirement plans, but roughly 85% of plans do, according to a Deloitte survey.

The formulas companies use to determine how much they contribute vary, but the most common are partial and dollar-for-dollar matches. Some particularly benevolent employers kick money into worker accounts (a non-matching 401(k) contribution) even if the employee doesn’t chip in anything.

What is a partial 401(k) match?: The most common matching structure is a partial match. It means an employer puts in a matching contribution equal to a portion of the amount an employee saves, up to a set percentage of the worker’s salary.

Example of a partial 401(k) match: Let’s say an employer matches 50 cents of each dollar you contribute, up to 6% of your salary, and you earn $60,000. In order to take full advantage of the match, at that salary you’d contribute $3,600 (6% of your earnings) to your plan and the employer match would be $1,800 (50 cents of each dollar). Any money you contribute that’s more than 6% of your earnings will not get a company match.

What is a dollar-for-dollar 401(k) match?: Like it sounds, a dollar-for-dollar match means an employer contributes the same amount (100%) of the employee’s contribution. The matching amount is capped at some specific percentage of the worker’s salary, usually between 3% and 6%.

Example of a dollar-for-dollar 401(k) match: A common matching formula is a 3% dollar-for-dollar match. So if you earn $60,000 and contribute 3% of your pay ($1,800) to your 401(k), your employer would also kick in $1,800 to your account. On a 6% dollar-for-dollar match both you and your employer would contribute $3,600 a year to your workplace retirement account, with any additional money you save receiving no company match.

Besides the matching formula, you want to know if there is a vesting schedule. Any money you contribute to a 401(k) plan is yours forever. The company match, however, may not be yours right away. If your 401(k) has a vesting schedule, the employer contribution will gradually become your money over a period of time — typically a handful of years. If you leave the company, you’ll leave behind any unvested employer contributions. This is often what's known as "golden handcuffs."

Bottom line: If your employer offers matching contributions in its retirement plans, do what it takes to get the full match.

There are two primary differences between Roth IRAs and traditional IRAs:

1. How and when you pay taxes on contributions and withdrawals: Contributions to a traditional IRA are pre-tax, meaning you may be able to deduct the amount you save from your current year’s taxes (depending on some IRS-y things). Withdrawals in retirement are taxed as income.
   Roth IRA contributions are post-tax (you don’t get an upfront deduction), but withdrawals are completely tax-free.
2. How your eligibility to contribute is determined: Anyone can fully fund a traditional IRA, as long as you (or your spouse, if you don’t work) earn income in the year you make your contribution. Your ability to deduct the amount you save rests on whether you or your spouse has a workplace retirement plan. If one of you has access to an employer-sponsored retirement plan, then your household income and tax filing status determine whether you can deduct all, a portion, or none of your traditional IRA contribution.
   
   Roth IRA eligibility is based solely on how much you earn. Once you reach a certain income level, the IRS reduces and eventually zeroes out the amount you’re allowed to contribute.

There are other noteworthy differences (withdrawal rules) and similarities (account setup, contribution limits). We could go on and on about them … and we do in our comparison of Roth and traditional IRAs!

The answer to this question depends much on your own individual financial situation and the income level you expect to be in the future.

• Do you want to lower your tax bill this year, or save your tax break until retirement? The main feature of traditional IRAs is the potential upfront tax deduction. Roth IRAs provide tax-free withdrawals down the road because you don’t get to deduct your contributions. If you’re not sure, then …
• Are you currently in a low tax bracket? The Roth IRA is often the go-to choice for those just kicking off their soon-to-be-illustrious careers. Assuming your earning power increases over time, the tax-free withdrawals from a Roth in retirement will pay off more than a present-day deduction you can get by choosing a traditional IRA.
• Are you currently in a high-ish tax bracket (e.g., 25% or more)? If you envision your income leveling out or going down in retirement, taking the upfront deduction offered by a traditional IRA may be the better tax move.
• Will you need to access your IRA savings before age 59½? The Roth IRA is friendlier for withdrawal early birds because it allows you to tap your contributions (not earnings) without paying the 10% early withdrawal penalty.

A Roth 401(k) is like a 401(k), but with different tax rules and an extra word at the front to help you tell the difference.

With a Roth 401(k) you settle your tax bill with the IRS upfront by paying your income taxes on the money you contribute to the account. Once in the account, your money grows tax-free. When you withdraw funds from your Roth 401(k) in retirement, you owe nothing to Uncle Sam because you already settled the tab upfront.

The tax scenario is flipped with a regular 401(k). Contributions are made with pre-tax dollars (versus post-tax ones), which lowers your taxable income for the year. As with a Roth 401(k), you owe no taxes on investment growth while the money is in the account. But you can only postpone paying taxes for so long. When you tap money from a 401(k) in retirement, you’ll owe taxes on the amount you withdraw.

Quick Comparison: Roth 401(k) vs. 401(k)

Yes, you can invest in both an IRA and a 401(k) at the same time. Not only does the IRS allow individuals to save in both a 401(k) and an IRA at the same time (up to the allowable limits for each type of account), but doing so elevates your retirement savings game by providing:

• A bigger upfront tax break: If you’re trying to cut your current tax bill, maxing out a 401(k) and traditional IRA in the same year can help you shield up to $30,000 in income ($38,500 if you’re 50 or older) from income taxes.
• A fatter tax-free income stream in retirement: While you get no upfront deduction on contributions to the Roth versions of an IRA and 401(k), you get a big reward on your retirement distributions: tax-free withdrawals. Doubling down with a Roth IRA and Roth 401(k) means less tax agita when you tap your retirement savings.
• Tax protection for more of your retirement portfolio: Unlike money held in a regular brokerage account, investment growth within IRAs and 401(k)s generate no annual tax bill, as long as the money is in the account. That translates to decades of no taxes, allowing more of your money to compound over time.
• The option to mix-and-match tax breaks: If your workplace only offers a traditional 401(k), investing outside of it in a Roth IRA buys you access to tax-free withdrawals in retirement. Similarly, if you make too much money to qualify for a Roth IRA, a Roth 401(k) (if offered by your employer) is your all-access pass, since there are no income restrictions.
• Access to different types of investments: Workplace plans offer only a limited menu of investment options, many of which may be perfectly suited to your needs. If you want to invest in individual stocks or certain mutual funds that aren’t on the 401(k) menu, an IRA provides that flexibility.

The 4% rule says you can safely withdraw 4% of the money in a diversified retirement portfolio each year in retirement without running out of money for about 30 years. As with all rules of thumb, there are some caveats — more on those below. A handy side benefit of this rule is that it gives you a rough estimate of how much you should save for retirement: 25 times the amount of annual retirement income you need your retirement portfolio to produce.

A safe withdrawal rate is the percentage of your retirement savings in a diversified investment portfolio that you can safely withdraw each year while still having your money last about 30 years. The 4% rule is based on these assumptions:

Your money is invested in a diversified portfolio of at least 50% stocks and the rest bonds; you withdraw 4% each year; and starting in the second year, you adjust your withdrawal rate in line with inflation.

The original concept is based on a study that included the Great Depression and other crashes — 4% was found to be the safe withdrawal rate for a long-lived portfolio despite major market upheaval. The idea is, this is a super safe withdrawal rate.

The 4% rule simply connects a safe withdrawal rate to a lump sum of savings. Here’s how to make this work in real life:

• Figure out how much income you need each year in retirement. (For a very rough estimate, use your current annual spending amount, minus what you’re putting into retirement savings.)
• Next, subtract from that amount any other sources of retirement income, such as Social Security.
• The remaining number is the amount of income you need your retirement savings to produce each year.

For example, say you need a total of $70,000 a year in retirement, your expected annual Social Security benefit is $25,000, and you expect no other sources of retirement income. That means your portfolio needs to produce $45,000 a year. If you rely on the 4% rule, then you need to save a total of $1,125,000 (i.e. $55,000 times 25).

One more thing: It seems that for every financial expert who praises the 4% rule, there’s another one decrying it. Some people say 4% is too high a number; others say it’s too low and you can safely withdraw more. So use the 4% rule as a starting point rather than your do-or-die rule. For a takedown of some of the criticisms of the 4% rule, check out this blog post by Michael Kitces, chief financial planning Nerd at Kitces.com, and head of planning strategy at Buckingham Wealth Partners. Meanwhile, Morningstar, the investment research company, also has thoughts.

Bottom line: The 4% rule can be a useful tool for estimating how much money you need to save on the road to retirement, and how much money you can safely withdraw once you retire. As with all rules of thumb, however, your actual circumstances and needs may vary. Why not talk to a financial advisor before you retire?