Are You Using The Wrong Retirement Account?

Are You Using The Wrong Retirement Account?

September 2016

A A A

We all know we need to save for retirement, but let’s face it. We also have limited funds with which to save. With all the various tax-advantaged retirement account options available to use, it can be tricky to know which ones to prioritize with our limited savings. Making the wrong choice could cost us in higher taxes, less flexibility, or even missing out on free money. Here are some factors to consider in making sure you’re getting the full value out of your tax-advantaged retirement accounts:

1) Are you eligible to contribute to a Roth IRA?

If you have some earned income and your modified adjusted gross income is below $132,000 single or $194,000 married filing jointly, you’re eligible for at least a partial contribution to a Roth IRA. The main advantage of a Roth IRA is that any earnings are tax-free as long as you’ve had the account open for at least 5 years and are over age 59 1/2. (Up to $10,000 of earnings are also tax-free if you’ve had the account for at least 5 years and use the money for a first-time home purchase.)

Since you can also access the contributions any time and for any reason without tax or penalty, it could double as your emergency fund. (Any earnings you withdraw could be subject to taxes and an early withdrawal penalty, but all your contributions come out first.) If you already have emergency savings, you can simply contribute them to a Roth IRA up to the annual limit. Just be sure to keep the Roth IRA somewhere safe and accessible like a savings account or money market fund until you’ve built up an adequate emergency fund (enough to cover at least 3-6 months’ worth of necessary expenses) somewhere else. At that point, you can invest the Roth IRA more aggressively to grow tax-free for retirement.

If you don’t have an emergency fund, having at least a few thousand dollars in cash reserves should be your first priority. Otherwise, you could find yourself raiding another retirement account (and possibly paying early withdrawal penalties) or falling behind on rent, mortgage or car payments in an emergency. Having to complete a withdrawal form to tap your Roth IRA could also discourage you from tapping it for frivolous things.

2) Does your employer match retirement plan contributions?

If so, maxing that match should be your next priority. Where else are you going to get a guaranteed return on your money? Don’t leave that free money on the table! Of course, you also get all the other benefits of your retirement account like pre-tax or Roth contributions and tax-deferred or tax-free growth, possibly low cost or unique investment options, the ability to borrow against it and pay yourself the interest, and creditor protections.

3) Are you eligible to contribute to a health savings account (HSA)?

If you’re enrolled in a qualified high-deductible health insurance plan, you can make pre-tax contributions to a health savings account and use the money (and any earnings) tax-free for qualified healthcare expenses. Whatever you don’t spend on health care now can typically be invested and used for any purpose penalty-free after age 65 as part of your retirement savings. The money could also be used tax-free to pay for qualified medical expenses in the future, including some Medicare and long term care insurance premiums. When you consider that you’ll most likely have medical expenses in retirement, you might even want to take it a step further and try to pay for healthcare costs from other savings. This allows the HSA money to grow as much as possible to be used tax-free for healthcare costs in retirement.

4) Are you eligible to contribute to a 457 plan?

This retirement account is available to many public sector employees and has the same tax benefits and contribution limits as a 401(k) and 403(b). However, there is no early withdrawal penalty. This added flexibility gives it a priority over the others if you’re under age 55.

5) Have you maxed out your employer’s retirement plan?

If not, this should be your next priority for all the non-match reasons given under #2. Keep in mind that even if you’ve hit your pre-tax/Roth limits, your plan may allow you to contribute after-tax. It’s not that advantageous on its face because the earnings are taxed at ordinary income tax rates when they’re withdrawn rather than the more favorable long term capital gains rates you could get by investing outside the retirement account.

However, you can convert the after-tax dollars to a Roth account so they can then grow to eventually be tax-free.  Some plans allow you to do a Roth conversion while you’re working there. Otherwise, you can convert it to a Roth IRA after you leave.

6) Are you ineligible to make a full Roth IRA contribution?

If your income is too high (a nice problem to have), you can still contribute to a traditional IRA and then convert it to a Roth IRA. There are a few things to keep in mind though. First, the IRA limits apply to all IRAs that year so if you made a partial contribution to a Roth IRA, it reduces the amount you can contribute to the traditional IRA. Second, you have to wait at least 5 years after the conversion before being able to withdraw the money you converted penalty-free.

Finally, if you have other pre-tax IRAs, you might want to see if you can roll them into your employer’s retirement account. Otherwise, you’ll have to pay taxes on part of the IRA you convert to a Roth even if it was all after-tax money. You can learn more about this here.

7) Are you investing tax-efficiently?

If you’ve maxed out all of your eligible tax-advantaged accounts, you can still save and invest for retirement in a regular investment account. Since your interest, dividends, and capital gains will be taxed each year, you’ll want to use this account for the investments that generate the least taxes. That means individual stocks and ETFs, low turnover mutual funds, and municipal bonds. Taxable bonds, high turnover mutual funds, and REITs should be held in the tax-sheltered accounts as much as possible. If you’re not sure how to do that, it could be a good reason to hire a financial advisor or use a tax-aware robo-advisor.

As you can see, knowing which accounts to contribute to first isn’t always straightforward. If you’d like additional help making this decision, consider consulting a qualified and unbiased financial professional. Don’t let this lead to analysis paralysis though. Contributing to a less than ideal account is still much better than not contributing at all.

 

This article was written by Erik Carter from Forbes and was legally licensed through the NewsCred publisher network.

BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally.  This material does not constitute a recommendation by BNY Mellon of any kind.  The information herein is not intended to provide tax, legal, investment, accounting, financial or other professional advice on any matter, and should not be used or relied upon as such.  The views expressed within this material are those of the contributors and not necessarily those of BNY Mellon.  BNY Mellon has not independently verified the information contained in this material and makes no representation as to the accuracy, completeness, timeliness, merchantability or fitness for a specific purpose of the information provided in this material.  BNY Mellon assumes no direct or consequential liability for any errors in or reliance upon this material.