In a previous article, we discussed whether you should pay off credit card debt or save for retirement. In that article, we discussed contributing enough to your employer’s retirement plan to earn a full match on your contributions, then tackling your high interest credit card debt. But what if you have no expensive debt to pay down and you’re getting the full employer match? Where should you direct your money? Here are some suggestions.
Related: Should you save for retirement or pay off credit card debt?
Unmatched 401(k) contributions
In 2017, employees can contribute up to $18,000, or $24,000 if they’re at least age 50. Few (if any) company matches are that generous.
Example 1: Julie Benson earns $100,000 a year. Her employer’s 401(k) match is dollar-for-dollar, up to 6% of pay. So Julie will put at least $6,000 into the plan this year to get her full 6% match. Julie, age 45, could contribute another $12,000 to her company retirement plan. This additional contribution would not earn an additional employer match.
The amount contributed won’t be subject to income tax and any investment earnings can compound, untaxed. Other possible advantages include access to plan loans, offered by many companies, and considerable shelter from creditors.
That said, the main benefit of an unmatched 401(k) contribution is tax-deferred investing. If you are in a relatively high tax bracket now and expect to be in a lower bracket when you take withdrawals in retirement, maximizing 401(k) contributions could pay off. On the other hand, tax deferral might not appeal to workers in their 20s with modest incomes, perhaps deferring tax in a 15% bracket, who will face uncertain tax rates on distributions decades from now.
Roth IRA contributions
A Roth IRA is always funded with after-tax dollars, so there is no upfront tax benefit. But the investment is tax-deferred, like your employer’s retirement plan. And distributions from a Roth IRA are completely tax-free if you meet the requirements. Your distribution must be made after the 5-year period beginning with the first tax year of a contribution to a Roth IRA. The distribution also must be made after the Roth IRA owner reaches age 59½. Therefore, putting some money into a Roth IRA can provide a source of tax-free cash in retirement instead of, or in addition to, taxable withdrawals of money from a 401(k). Roth IRA contributions can be up to $5,500 in 2017, or $6,500 for those 50 or older.
Example 2: Assume that Julie Benson, with her $100,000 salary, desires to save $15,000 for retirement this year. Julie considers contributing $6,000 into her 401(k) to get the match plus a $5,500 Roth IRA contribution. That would total $11,500, so Julie could achieve her $15,000 savings goal by contributing another $3,500 to her 401(k) without a match.
Roth IRA owners never have required distributions, which generally impact pretax retirement funds after age 70½. It’s true that income limits may crimp Roth IRA contributions¾single taxpayers can’t contribute for 2017 with modified adjusted gross income of at least $133,000, or $196,000 on joint tax returns.
However, there are no income limits for making nondeductible contributions to a traditional IRA and then converting that amount to a Roth IRA. This workaround won’t generate income tax for people who have no pretax money in traditional IRAs.
Roth IRAs may be especially appealing to people in relatively low tax brackets now, who will get only modest tax savings from unmatched 401(k) contributions.
Health savings accounts
Another possibility exists for people with certain high deductible health insurance coverage. Besides paying for the insurance, such people can have a health savings account (HSA) that offers unique tax advantages.
HSAs have no income limits. Tax deductible contributions can go up to $3,400 for 2017 and up to $6,750 for those with family coverage. (People 55 or older can contribute $1,000 more.) Inside an HSA, your investment grows tax-free. And the HSA owner does not pay tax on distributions if the HSA owner spends at least that much on qualified health care costs.
Example 3: Suppose that Julie Benson is eligible for an HSA. With single coverage, Julie contributes $3,400 this year, which she invests in stock funds. Although past performance is no guarantee of future success, stocks historically have done well over long time periods. Therefore, Julie hopes that annual contributions to her HSA will provide her with a substantial fund to tap for medical bills in retirement.
Besides contributing $6,000 to her 401(k) to get the full match, and $3,400 to her HSA, Julie can still contribute $5,500 to a Roth IRA for a total of $14,900 in 2017. These three savings options each have features that go beyond those mentioned in this article. But they all may be viable choices for retirement investing. Our office can explain their tax impact on your particular situation.