Huge Advantage 401(k) Savers Enjoy Over Those Using an IRA
Stuck with an IRA? Max it out. And how about spouse IRA and SEP-IRA?
In 2020, anyone with a workplace retirement plan they contribute to can pony up even more money. The IRS adjusts the annual contribution limit to keep pace with inflation. For 2020, if you’re younger than 50 you can pile as much as $19,500 into a 401(k), 403(b) or similar defined-contribution plan. That’s up from $19,000. If you’re 50 or older, the 2020 limit is $26,000.
Granted, $26,000 is going to be out of reach for many households, given the median household income is less than $65,000.
According to Vanguard’s analysis of 401(k) plans it administers, less than four in 10 participants that made at least $100,000 are estimated to have contributed the maximum in 2018, and only 3% of participants with income between $50,000 and $100,000 hit the 401(k) contribution limit.
Still, even if you don’t max out, a workplace plan holds a big advantage over saving in an IRA. For 2020, there is no inflation adjustment for IRA contributions. The limits remain at $6,000 if you’re under 50 and $7,000 if you’re at least 50.
For those curious about the disparity between the two popular retirement savings accounts, Aron Szapiro, director of public policy at Morningstar, explained that the 401(k) limits have to be demonstrably higher to entice employers to sponsor a workplace plan. “Policymakers believe it is necessary to maintain this unfairness because extra tax incentives induce employers to offer a retirement plan when they otherwise might not,” Szapiro wrote.
That explicit unfairness has broad impact. According to federal data, just 60% of workers have access to a workplace retirement plan they can contribute to. For the other 40%, some may have a pension, but most do not. So their only tax-advantaged way to save for retirement is through an IRA, with its unfair lower contribution limits.
If you’re dependent on IRA savings, here’s how to wring out the most value:
Set up automatic deposits. The surest way to hit the annual maximum is to arrange periodic direct deposits from a checking account into an IRA account. Discount brokerages provide this service for free, and you can invest in low-cost index mutual funds and exchange-traded funds.
Consider a Roth IRA if the notion of tax-free withdrawals in retirement appeals. There are two types of IRAs: traditional and Roth. With a traditional IRA you may be eligible to deduct the amount of your contribution from this year’s tax bill. Just keep in mind that in retirement every dollar you withdraw from a traditional IRA will be taxed at your ordinary income tax rate. A Roth IRA does not provide any upfront tax deduction — you contribute money that has already been taxed — but in retirement, every dollar you withdraw is tax free. In 2020, individuals with income below $124,000 and married couples with joint income below $196,000 can contribute the max to a Roth IRA.
Take advantage of a spousal IRA. If you are married and one spouse is not earning income, they can still have an IRA. All the IRS cares about is that the household’s earned income is at least equal to the total both spouses contribute to an IRA. For a couple where both are under 50, that means each can tuck away $6,000 this year, assuming the wage earner made at least $12,000.
Self-employed or have a side gig? Use a SEP-IRA. If you are self-employed, or you do any gig work in addition to an office job, you are eligible for a SEP-IRA. The contribution limit is way better than a standard IRA. In 2020, you can contribute 25% of your net earnings up to $57,000. If you had net earnings of $50,000, that would translate to being able to contribute $12,500. One issue with SEP-IRAs: There is only a traditional SEP-IRA option; there is no SEP Roth option.