Death and taxes are the only two certainties in life. While one is unavoidable, taxes can be minimized with strategic planning.
For investors, that means utilizing tax-advantaged accounts, including 401(k)s and individual retirement accounts, to the fullest. John Vento, president of Comprehensive Wealth Management in Staten Island, says the higher contribution limits and the potential for employer matching contributions are the main draws of 401(k) plans.
“Saving for retirement through your 401(k) is like putting your retirement plan on autopilot,” Vento says. “The added benefit of saving through your paycheck is that you’re taking advantage of dollar-cost averaging with your investments over time.”
The automatic nature of 401(k)s also encourages self-control.
“Human behavior loves the path of least resistance when it comes to money matters, savings in particular,” says J. Timothy Corle, president and CEO of Tycor Benefit Administrators in Berwyn, Pennsylvania. He says having retirement contributions deducted from your paycheck automatically instills the discipline to save over the long-term.
But, there are some scenarios where placing contributions in a traditional or Roth IRA ahead of your 401(k) could make sense. If you’re able to save in multiple tax-advantaged accounts, getting the order of operations right matters.
Check the match. Whether your 401(k) should be your go-to savings choice depends largely on if the plan offers a matching contribution.
“If the employer plan does not offer a match, then an IRA is a much better place to start,” says Brad Clark, president of Solomon Financial in Indianapolis.
Clark says if you’re thinking of maxing an IRA before your employer’s plan to weigh the benefits of Roth versus traditional IRAs.
A Roth could make more sense if you anticipate being in a higher tax bracket when you retire and want to take advantage of tax-free qualified withdrawals, without the pressure to take required minimum distributions starting at age 70½.
“Remember, there’s only one way for the government to raise money, and that’s to raise taxes,” says Dale Wolberg, president and owner of Focused Financial Solutions in Littleton, Colorado.
If you’re already saving in a traditional IRA, you may have the option of converting to a Roth later, Wolberg says.
The tax benefit there is that once you convert from a traditional to a Roth account, “going forward, everything grows tax-free,” says Tatyana Bunich, president and founder of Financial 1 Wealth Management Group in Columbia, Maryland. But, you’ll pay taxes on your IRA at the time of the conversion.
Bunich says investors must consider their age and tax situation before a conversion.
“They then have to decide if it makes sense, how much makes sense and if they’re comfortable paying the tax bill because it could be significant,” she says.
Compare investment options and fees. The gap between 401(k)s and IRAs can be wide when it comes to investment choices and fees. Dan Routh, certified financial planner and wealth advisor at Exencial Wealth Advisors in Oklahoma City, says poor investment options and high fees are two reasons investors may choose to max out their IRA before fully contributing to their workplace plan.
“401(k)s usually have set investment menus for participants, which are chosen by the officers of the company or outside advisors,” Routh says. “Sometimes, these lists are not as plentiful as the investor would prefer or as diverse within the specific options.”
IRAs, on the other hand, can offer thousands of investment choices.
While 401(k) fees have been on a steady decline over the last decade, that doesn’t automatically make them a better bargain.
“Fees are an area investors have virtually no control over in their 401(k) plans,” Routh says. That includes the advisor/trustee fees, record-keeper fees and expense ratios for individual investment options. If your IRA charges lower fees you may be motivated to max it out first to keep more of your earnings.
Think about timing. One significant difference between a 401(k) and IRA is that IRA contributions are always yours. With a 401(k), you may have to follow a vesting schedule before all the money in your account officially belongs to you. That matters if a job change may be in the cards at some point.
“If you don’t expect to spend enough time with the employer to become fully vested, an IRA might be a better choice, since it’s fully portable,” says Kimberly Foss, president of Empyrion Wealth Management in Roseville, California.
If you’ve fully funded your IRA, that money would be accessible to you without having to worry about rolling it over to a different account or missing out on contributions that aren’t vested.
Don’t forget about your HSA. Health savings accounts are designed for retirement savings, but they can be useful in supplementing a 401(k) or IRA.
“Health savings accounts offer investors enrolled in high deductible health plans the ability to make tax-deductible savings with tax-deferred growth, while benefiting from tax-free distributions for qualified health expenses,” says Celeste Hernandez-Revelli, certified financial planner and manager of financial planning at eMoney Advisor.
Unlike a flexible spending account, you can roll your HSA balance over year to year. After age 65, you can tap your HSA for any retirement expense, not just health care, without incurring a tax penalty. Your distribution would still be taxable, similar to distributions from a 401(k) or traditional IRA.
And like an IRA, HSAs are portable as long as you remain enrolled in your high deductible health plan, Hernandez-Revelli says.
It’s not either/or. Prioritizing contributions to your IRA doesn’t mean counting out your 401(k), or vice versa. You can do both; you just have to decide where you want to allocate your investment dollars first.
“If an investor opts to first fully fund their IRA, it would be wise to contribute enough to their employer plan to fully benefit from the employer match,” says Angela Coleman, fiduciary investment advisor at Unified Trust Company in Lexington, Kentucky. “The concept of leaving free money on the table never makes sense.”
Planning out your contributions with the help of an advisor can help you clarify where to get started.
“Sit down with your financial advisor at the end of the year and talk about where and how you should be saving,” says Martin Schamis, vice president and head of wealth planning at Janney Montgomery Scott in Philadelphia.
He says there’s a lot to consider, including your 401(k) match, your tax bracket and how disciplined you are in saving consistently.
“When you throw in maximizing your 401(k), Roth contributions and whether you qualify or don’t, it could all get complicated,” Schamis says, “but the worse thing you can do is not have any strategy in place.”
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