3 Simple Steps to the Perfect IRA

Choosing the most efficient tax-favored retirement savings strategy can be challenging. Here's how to get it right in 3 simple steps.

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Choosing the optimal tax-favored retirement savings account is always confusing, and it hasn’t gotten any easier this tax season. A Schwab survey shows that 53% of Americans don’t understand at least one basic aspect of IRAs. Roughly one in four don’t understand the tax rules or how various IRA products differ.

But you’ll end up in the right place if you ask yourself three basic questions, according to a report from mutual fund company T. Rowe Price. Here’s how to prioritize your tax-favored retirement savings accounts:

  • Do Roth contributions make sense for me? Roth IRAs are almost always a great choice, especially for young people in a low tax bracket and with many years of compound returns ahead. You put in after-tax money, which grows tax-free. Roth IRAs have the most flexible withdrawal rules and they are great for leaving assets to heirs. But you might not want a Roth if you are near retirement and expect your tax rate to fall soon. If you conclude that the Roth is not for you, contribute the max to your regular pre-tax 401(k) and after that max out a traditional IRA. If you like the Roth, here’s the next question:
  • Does my employer offer a Roth contribution option within my 401(k)? The so-called Roth 401(k) is another good option. This account functions a lot like the basic Roth, except it is wrapped inside an employer-sponsored program. You make after-tax contributions; so your take-home pay may take a hit. Any company match is put in a separate account funded with pre-tax dollars. Again, this option may have the most appeal to younger people looking forward to years of tax-free compounding. You might want to skip it if you are near retirement and expect your tax rate to fall. Whether you answer yes or no, move on to the final question:
  • Am I eligible to contribute to a Roth IRA? All employees are eligible for the Roth 401(k), assuming their employer offers one. But with the basic Roth there are income restrictions—singles making more than $125,000 or couples making more than $183,000 are excluded. (They may, however, convert a traditional IRA to a Roth.) If you answer yes to this last question and also answer yes to the previous question, contribute the max to your Roth 401(k), then to a regular Roth. If you answer yes to this last question but no to the previous question, contribute enough to your regular pre-tax 401(k) to get the full company match, then contribute the max to a regular Roth, and then max out your regular pre-tax 401(k). If you answer no after answering the previous question yes, contribute the max to your Roth 401(k), then to a traditional IRA. If you answer no after answering the previous question no, contribute the max to your regular pre-tax 401(k), then to a traditional IRA.
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This simple question and answer process should make your tax-favored savings strategy clear. You may find it helpful to view this process in chart form.

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