Last week I listed a bunch of mistakes people make in planning for retirement. One of the trickier decisions of saving for retirement is determining which accounts to prioritize with your savings.
Is it most important to max out a 401(k) before an IRA? At what point should you use a taxable account for retirement savings? How does debt play into these decisions? This is one of those truly personal finance moments because everyone has different circumstances.
To simplify the many options for retirement investing along with multiple variables that go into the decision making process, here is the general order that I recommend saving for retirement.
1. Invest enough in your company retirement plan to earn a match.
It’s hard to find a guaranteed 100% return on your investment, but an employer match does just that. If your employer offers a match on some portion of your 401(k) contributions, invest at least that much. Otherwise, you leave free money on the table.
For example, if your employer has a 3% match and you make $100,000 a year, you’ll need to contribute at least $3,000 of your own money to your 401(k) to be entitled to your employer’s full matching contribution. Once you invest at least enough in your employer plan to receive the match, then move on to the next bucket.
If your employer doesn’t offer a match, skip this first item and move to number 2.
2. Invest in Roth IRA or deductible Traditional IRA.
Your ability to invest in a Roth IRA of deductible Traditional IRA depends on your income. If you’re eligible for a Roth IRA, then this is the next place to direct retirement savings. For most people that are not near retirement, the flexibility and tax-advantages make the Roth a no-brainer. If you can’t invest in a Roth account, the next best option is to make contributions to a traditional IRA, so long as you are able to deduct the contributions from your income.
Both Roth and Traditional IRAs allow your money to grow tax-free, but the difference is the timing of tax payment. A Roth IRA is funded with after-tax dollars, meaning your contributions don’t receive a tax deduction. But your withdrawals from a Roth IRA are tax free. A Traditional IRA, on the other hand, is funded with pre-tax dollars – you deduct the contribution from your income – and withdrawals are taxed as ordinary income.
If your income is too high to qualify for a Roth IRA or a deductible Traditional IRA, you can still contribute to a nondeductible IRA and enjoy tax-deferred growth, but that option is a little further down the list.
3. Invest the maximum allowable amount in your company retirement plan.
If you have a good 401(k) plan, then it might make sense to prioritize this account before the IRAs described above. It’s difficult for many individuals to tell if they have a good or bad plan, but there are several items you can objectively evaluate.
When you are ready to contribute to your company retirement plan, you may have the choice of utilizing a traditional 401(k) or a Roth 401(k). If you expect to be in a higher tax bracket during retirement than you’re in today, the Roth 401(k) is the superior option. If you expect to be in a lower tax bracket during retirement than you are today, the Traditional 401(k) is the option for you.
If you aren’t comfortable projecting whether your taxes will be higher or lower at retirement, consider making contributions to both the Traditional and Roth options. This strategy is known as tax diversification.
4. Invest in Traditional nondeductible IRA.
The nondeductible Traditional IRA has no tax break for the money when it goes in during your working years and withdrawals are taxed as ordinary income during your retirement. You will, however, enjoy the benefit of tax-deferred compound growth.
For some investors, contributing to traditional nondeductible IRAs and converting the balances at a later date to a Roth IRA may prove advantageous, particularly if they expect to be in a higher tax bracket (or expect taxes to be higher for everyone) when they want to withdraw the money in retirement.
When you convert an IRA into a Roth IRA, you have to pay ordinary income taxes on any appreciation and earned income experienced in any of your IRA accounts, not just the account being converted. The decision to convert a Traditional IRA to a Roth IRA requires an analysis of the tax cost, your life expectancy, and the desired beneficiary of the assets.
In my opinion, too many people convert some or all of their Traditional IRAs to Roth IRAs. I believe that financial advisors and brokers recommend it more frequently than they should because people love the idea of “beating the system” using a perceived loophole in the tax code, but it is only a slam dunk if you don’t have much appreciation or earned income in the lifetime of your IRAs. That means, the Roth conversions tends to benefit younger investors with shorter lived IRAs.
5. Invest in taxable account.
If you’ve reached this point, congratulations! You’re doing a nice job of saving for your retirement. While you’ve exhausted the best tax-advantaged options, you can always save in a taxable account. The key here is to be very aware of the tax efficiency of any investments you select. Assuming you are utilizing the tax-advantaged retirement accounts above, there are likely opportunities for you to benefit from asset location strategies.