Katie Martin, CFA, CFP®
August 2, 2021
Last month’s post walked through some ins and outs of the different kinds of retirement accounts. So now you may be wondering how to decide where your next dollar of retirement savings should go. As with most things, there’s no one right answer. However, there are a few factors to consider to determine how you should allocate those hard-earned dollars you are investing for your future.
The biggest consideration is taxes – whether you want to pay taxes on the money today or when you withdraw the money in retirement. In general, if you are just starting out in your career and expect to be in a higher tax bracket in retirement, it probably makes sense to invest in an after-tax savings vehicle (like a Roth 401(k) or Roth IRA) today. On the flip side, if you’re in your mid- to late-career and are in a higher tax bracket, it likely makes sense to invest pre-tax dollars to get the break today.
However, one factor that is easy to overlook is the diversification of how your income is taxed in retirement. Even if you are in a higher tax bracket today, it could still benefit you to invest some after-tax money now in order to have a bucket of funds from which you can withdraw tax-free in retirement. If you simply maximize the contributions to your pre-tax 401(k) year after year, you could end up with a significant balance in your 401(k) at retirement. Yes, that’s a good thing, but the size of the required minimum distributions (RMDs) you will start taking at age 72 might be larger than you expect. Large RMDs can mean paying higher taxes on the distributions themselves, as well as paying higher taxes on Social Security benefits and higher premiums for Medicare. This is often one of the biggest surprises clients approaching retirement encounter when we go through the financial planning process
So, all that considered, how should you think about investing that next dollar for retirement?
Invest to get your match – You’ve likely heard this before, but it bears repeating just in case. If your employer provides a matching contribution for what you put into your 401(k) or 403(b), a good rule of thumb is to invest enough to earn the maximum matching contribution before considering other retirement vehicles, like an IRA. Otherwise, you’re leaving “free” money on the table.
If your employer offers a Roth 401(k) option and you’re in the early stages of your career, you may consider making these contributions to your Roth 401(k). (The match will be deposited into the pre-tax 401(k).) If you are in a higher tax bracket, you might consider investing in the pre-tax 401(k) to earn your match and save on taxes today.
Invest in a Roth savings vehicle – Once you’ve earned your match, it may make sense to consider putting some money into a Roth savings vehicle. This can be done by contributing directly to a Roth IRA (if you are under the income limits), through backdoor Roth IRA contributions (if it makes sense for you), or by splitting your 401(k) savings between Roth and pre-tax 401(k) options (if both are choices in your employer’s plan.)
Seek to maximize your 401(k) contributions – The value of investing in your 401(k), either via pre-tax or Roth contributions, is tax-deferred growth prior to retirement. Seeking to maximize the amount that can grow tax free by contributing as much as you’re allowed to your 401(k), which is $19,500 for those under 50 in 2021, is a good goal.
Invest in a taxable account – If we’re strictly talking about saving for retirement, it typically makes sense to take advantage of tax-deferred growth before investing money in an account that will be taxed as you go. However, taxable accounts may move up higher on the list if you’re seeking more flexibility on when and how you can use the money you are saving.
While these are some helpful considerations, the best way to detail your retirement savings plan is to go through the financial planning process. This ensures your savings strategy is aligned to your goals and the things you are trying to achieve in your life. In addition, your trusted tax advisor can also provide guidance on what makes most sense given your specific situation.
This blog post is intended for general information only and should not be construed as personalized investment, legal, or tax advice. The information is based on sources believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Statements made in this blog may be subject to change depending on revisions to the tax code, statutes, regulations, or government policy. Please consult your accountant, attorney, or financial advisor prior to engaging in any legal, investment, or tax strategy.