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Four Questions to Ask When Funding Retirement Accounts

Neary Ting, Eagle Invest Advisor, First Republic Investment Management
March 23, 2017

When it comes to retirement planning, you’ve probably asked yourself: IRA or 401(k) – which comes first? Both are great options worth considering, so provided you meet certain baseline conditions, you don’t have to pick one or the other if you’re looking to maximize tax-deferred retirement savings. For example, if you contribute to your company’s 401(k) plan, there’s no reason you can’t also fund a traditional IRA or Roth IRA depending on your income eligibility. The trick is to determine how to prioritize allocations between the vehicles in a way that will enhance your savings goals. It’s also important to keep in mind that funding a traditional IRA may not be tax-deductible for those earning above certain income thresholds.  

With all of this in mind, here are four questions that can help you plan your optimal contribution strategy:

1.      Does your employer offer a 401(k) match?
The answer is very likely yes as on average, three in every four 401(k) plans do. And if you don’t take advantage of your matching options, you’re essentially choosing to decline a portion of your salary.

Here’s a common scenario: For the first six percent of an employee’s 401(k) contributions, the employer will contribute an additional 50 percent of that amount. So, if you make $100,000 per year and contribute six percent — or $6,000 — your employer would then add $3,000 to that total, giving your account balance a significant boost.

Self-employed? Establish a solo 401(k) and you can contribute up to $18,000 as an employee as well as an additional 20 percent of income as an employer, up to a total of $54,000 ($60,000 if you’re 50 or older) per year.

If your employer doesn’t offer a match, you might consider applying those initial funds to your IRA instead.

2.      Do you qualify for IRA tax advantages?
The catch with most 401(k) plans is that you’re limited to the investment options within the plan, which commonly include a predetermined selection of diversified equity and fixed-income mutual funds. 

A self-directed IRA, on the other hand, offers you the freedom to invest in a much broader universe that can include a wide array of diversified and specialty mutual funds, stocks, bonds, CDs, ETFs and more.

There are two types of IRAs: traditional and Roth. Traditional IRAs allow for a tax deduction (in accordance with income limitations), which effectively decreases taxable income for the year the contribution is made. Roth IRAs, meanwhile, are funded with after-tax dollars. Their main advantage is that all earnings grow tax-free and you won’t owe any income tax on Roth distributions when you retire.

The IRA can be an alluring retirement option; just be aware that the annual contribution limit is low — just $5,500 per year ($6,500 if you’re 50 or older). As mentioned previously, there are also income limits: A single-filer will start to see tax benefits phased out for the traditional IRA after a $62,000 salary. For a single-filing Roth IRA investor, the allowable contribution will start to decrease at an $118,000 salary.

Self-employed business owners have a few other options. Open a SEP IRA, for example, and you will be allowed to contribute 25 percent of your income, up to $54,000. SIMPLE (Savings Incentive Match PLan for Employees) IRA owners, meanwhile, can contribute up to $12,500 ($15,500 if over age 50), plus a two to three percent match, depending on how you set up your plan. If you have employees, however, both plans may also require mandatory matching payments for each of your workers.

3.      Should I select a Roth or traditional option?
The two-flavor option isn’t just for IRAs. Almost half of all 401(k) plans offer the Roth option, too.

For most investors, the choice boils down to whether you expect your taxes to be higher today or when you retire. When you consider the fact that only part of the equation will be within your control, it’s a bit of a trick question.

First, there’s the income you expect to draw from your retirement accounts once you reach those golden years. Plan to live on less than you earn today and you could be in a lower tax bracket.

That’s only the first half of the equation, though. It’s next to impossible to predict long-term tax policy. The top marginal rate has fluctuated between 24 and 94 percent during the past 100 years, but there’s no telling where it will be after we’ve lived through the next several decades.

An online calculator can help remove some of the guesswork. Still, some investors opt to hedge their tax bets, investing a portion in each type of account. That way, you can reap the benefit of today’s tax deduction while, at the same time, prep a solid source of future tax-free income.

4.      How much cash do I need to have on hand?
For many long-term investors, there’s the question of how to balance the need for cash now with the desire to stash as much as possible away for retirement goals.

Saving for retirement is important — the earlier you start, the better off you’re likely to be — but it’s important to keep an ample supply of easy-to-access cash on hand so you’re prepared to meet your shorter-term goals, like buying a home or paying your child’s tuition. Tapping your retirement fund early can come with a costly 10 percent tax penalty. Map out your short-term goals ahead of time and you won’t be tempted to cash in on those hard-earned retirement savings dollars.

In short, the key is to invest in the vehicles that offer the greatest potential for both financial gain and retirement preparation. For most long-term retirement investors, that means:

  • Start by ensuring you’re on track to receive your employer 401(k) match
  • Think about funding your IRA (traditional or Roth) depending on income limitations and tax-deductibility
  • Then, circle back to max out your 401(k)

The strategies mentioned in this article may often have tax and legal consequences; therefore, it is important to bear in mind that First Republic does not provide tax or legal advice. Investors' tax and legal affairs are their own responsibility and readers should consult their own attorneys or other tax advisors in order to understand the tax and legal consequences of any strategies mentioned in this document.

This article is presented as-is.

© 2017 First Republic Investment Management