During the earlier years of their careers, many investors are strapped for funds. They're often juggling mortgage payments, saving for children's education, and saving for their own retirement. But as they get closer to retirement, particularly when the kids have moved out, they have additional funds available for retirement saving. Many of these investors can then afford to fully fund their 401(k) plans--at least to the full match--and still have additional savings funds available.
That raises the question: What type of account should they use to maximize the return on their savings? Depending on their situation, they may face a choice between options that generate current deductions with tax-deferral (traditional IRAs, for example), no current deduction but tax-free growth (Roth IRAs), or tax-deferred accounts, such as annuities.
Vanguard's Investment Counseling & Research Division recently published a paper, "Investing for Retirement: Strategies for Taxable Investors," which discusses the account-selection process. The report notes that investors and advisors should consider multiple factors when deciding where to invest their retirement savings.
Fran Kinniry, a principal with Vanguard's Investment Strategy Group, says the first basic decision is to take full advantage of any employer savings-match to the fullest extent. Once that account is funded, a key factor is the anticipated income tax rate in retirement. "It gets down to that tax consideration of where you are today versus the future," he says. "If you're going to be in the same tax bracket today as the future, the location of the savings really doesn't matter all that much."
The report provides guidelines for the basic tax-related decisions:
o An investor should try to pay taxes at the time he or she expects income tax rates to be the lowest.
o If the investor's tax rate in retirement is expected to equal the current rate, it may make no difference whether the investor pays taxes on the investment today or 10 or 20 years from now. In other words, a Roth IRA and a 401(k) are equal in this scenario, so the investor should consider investing in both types of vehicles as a hedge against a change in future rates.
o If the investor expects to pay a higher tax rate in the future, a Roth IRA may be the better investment vehicle. The investor will pay income taxes today on contributions, but the investment will grow tax-free and withdrawals will not be taxed as long as the investor has owned the Roth IRA for at least five years and is at least age 59 1/2.
o For an investor who expects his or her tax rate to decline in the future, the better vehicle may be a pre-tax 401(k) or a deductible traditional IRA. The investor will pay income taxes on withdrawals from either of these accounts, but contributions are made in pre-tax dollars.
"Investing for Retirement: Strategies for Taxable Investors" is available on Vanguard's website at: www.vanguard.com/pdf/icrrss.pdf?2210035724.