Save for Retirement part 2 – What type of account should I use?
I am going to write about tax advantages and retirement savings. OOOOOOOOHHHHHH, did I have you at “tax advantages?” Did I also tell you that I didn’t date much in my younger years? True facts about John Chesbrough.
Most people worry about retirement (will I have enough?) hundreds of times in their lives. But how often do people really analyze their retirement savings strategy? My guess is somewhere around once per decade, or as often as they change jobs. This is actually not a bad thing. Good retirement savings strategies include ideas like “save more” and “set it and forget it.” But, there are good ways to save for retirement, and there are gooder-er ways. (that’s for my mom, AKA “Grammar Grandma,” who will have a small coronary at this point). This blog post describes some factors to consider in making a better retirement savings strategy. It is part 2 of my series about Saving for Retirement. Other entries:
Part 1: Save for Retirement 1: What is retirement? In this post, I discussed how the word retirement may not be the right word. For many, including myself, we are thinking about transitions and freedom more so than retirement.
(This post) Part 2: What type of retirement account should you use? The difference between “pay your taxes later” accounts (like a deferred compensation plan, 401k or traditional Individual Retirement Account, or IRA) and “pay your taxes now accounts” (like a Roth IRA).
Part 3: Use a tax diversified savings plan can help fund your retirement. How having money in both “pay your taxes later” and “pay your taxes now” accounts can be useful when you eventually need to access your money.
Make a “tax-diversified” retirement savings strategy for yourself. Save in both tax-deferred accounts (like a 401k, or deferred comp plan), AND in tax-exempt accounts like Roth IRAs. When you retire (or reach financial independence, AKA freedom-ment), you will appreciate being able to access funds with different tax ramifications. I will discuss why and how this works in part 3 of this series.
What do I need to think about when choosing a retirement strategy?
There are essentially three big questions to answer in setting up or evaluating your retirement savings strategy:
- What type of retirement account(s) should I open?
- How much do I need to contribute to reach my goals?
- How should I invest the money?
The answers, and actually whether there are a host of other questions, will depend on whether you are employed or self-employed. For those who are employed, your choices are likely constrained, and you just need to choose an option, like a multiple choice test. For those who are self-employed, your test is the essay version.
If you are employed
It is likely that your employer has focused your decisions to a small set of choices. For most people, that is a relief. Maybe you have a pension, or a 401k with an employer match, maybe you can save in a section 457 deferred compensation plan.
Whew. Easy. There aren’t too many things to decide on. Save as much as you can, invest similarly to co-workers you respect. Hopefully your employer has selected good options (with low fees and passively managed index fund choices). For example, as a government employee, I have been very happy with the retirement savings programs managed by the State of Washington. I generally like TRS, PRS, and Leoff-2. I think the Washington state Deferred Compensation program is well designed and managed. But, I am far less impressed by the privately-run 403b options given. There is one other tool that I think all employed persons should consider – the Roth IRA. I love the Roth IRA!
If you are self-employed
If you are self-employed, or you are a free-lancer, you have many more choices to make, including:
- What type of retirement account should I open?
- What company should I open the retirement account with?
- How much do I need to save every month?
- How will my taxes be affected by my choice of retirement account?
- How should I invest the money in my retirement account?
- Do I need to monitor my retirement account? How often?
Self-employed persons have the benefit and curse of needing to make all the choices by themselves. On one hand it’s great because you can design a strategy that fits you well. On the other hand, so many choices can lead to decision fatigue and paralysis. Many self-employed persons would prefer to delegate this job. That’s where you would want to engage the services of a low-fee robo-advisor (like Betterment), or a reasonable fee-only human financial advisor (who might provide many other benefits that a robot cannot).
Question 1 – What type of account should I use?
There are three different categories of retirement savings accounts based on special tax advantages:
Tax deferred accounts. I call these “pay your taxes later” accounts. When you contribute money into these accounts, you do not pay any tax on it now. However, the money is not tax-free. When you eventually withdraw the money, you must report all withdrawals as ordinary income, and the IRS will ask for its income tax.
Examples of tax-deferred accounts: 401k, Simple IRA, Simplified Employer Pension (SEP IRA), Deferred Compensation (457 plan), traditional IRA, or a TRS3 defined contribution.
Awesomeness of tax-deferred accounts: It seems as though you don’t pay any tax! Thus, your account investments can grow from a larger base, because you can likely contribute more money when you don’t have to pay taxes at the outset. Thus, your account balance will grow to a larger amount. Yay!
Non-Awesomeness of tax-deferred accounts: You have to pay tax when you withdraw it. Also, it can be tough to get your money back until you are retired or you separate from service. Different plan types will have different rules. Usually, there are exceptions for hardship withdrawals.
My favorite tax-deferred retirement savings account type: For those people who are employed, the best plan is usually the one your employer provides. For government workers in Washington state, the section 457 Deferred Compensation plans are excellent. For those who are self-employed, I like 401k plans. They have the most flexibility, they are reasonably easy to open and maintain, and contribution limits are high. Plus, if you need to access the money, you can take a loan out against your 401k and pay the interest to your future self rather than to the bank (careful, fees and tricky rules may apply). For a detailed discussion on 401k loans, see an excellent post referenced at the bottom of this article).
When should you maximize contributions to tax-deferred accounts? You should contribute enough to maximize any employer match you are offered. Also, you should contribute to tax-deferred accounts when your current tax rate is high compared to what you expect to pay in the future (very typical in the latter stages of your professional life).
Tax exempt accounts. I call these “pay your taxes now” accounts.
Examples of tax-exempt accounts: Roth IRA accounts, or other retirement accounts which have “Roth provisions.”
Awesomeness of tax-exempt accounts: When you withdraw your money, you won’t owe any tax. Full stop? Not quite, these are IRS rules, so of course the list of footnotes, “ahems,” and “except as reported on Form 6b489♠♣♥♦(i)”, is long. In general though, all of the money can be withdrawn without any tax consequence once you reach the age of 59 1/2. Before then, you can always withdraw your contributions without penalty. And, there are allowances for penalty-free withdrawals because of financial hardship, first-time home purchase, or paying for college.
Non-Awesomeness of tax-exempt accounts: You have to pay taxes on contributions. Contributions are limited to $5,500 per year per person, plus an additional $1,000 if you are over 50 1/2 years old. People who earn higher incomes may not be able to contribute directly to a Roth account.
My favorite tax-exempt account type: The Roth IRA. I love it!
When should you maximize contributions to tax-exempt accounts? When your tax rate is low compared to what you think it may be in the future (typical in the early stages of your professional life. Or, perhaps you are thinking, might future taxes be much higher as concerns about our US government debt lead to action?).
No special tax status account. This category may not appear to have any tax advantage but, in fact, there are clever tax strategies by using lower capital gains tax rates.
Examples of no special tax status accounts: Standard brokerage account, bank savings account, direct ownership of other investment (like rental property, gold coins, or a collection of never-been-opened Furbies).
Awesomeness of no special tax status accounts: If you don’t want special tax status, the IRS likely won’t get into your business. Thus, your funds tend to be very flexible. Plus, there are some tax-associated tricks, like 1031 like-kind exchanges, low rates of capital gains tax (vs. income tax), and a step-up in cost basis through inheritance.
Non-Awesomeness of no special tax status accounts: There are no special tax advantages.
My favorite tax-exempt account type: This completely depends on the person or business.
When should you maximize contributions to tax-exempt accounts? No special rules here, it depends on the individual.
Question 2 – How much should I save?
As much as you can. A very general rule-of-thumb is that if you save (and invest appropriately) 15%-20% of your salary per year for an entire working career, you will likely be ok. However, there are loads of details that affect this math. Answering this question is a primary component of good financial planning.
If you aren’t doing this now, and you aren’t yet retired, then get started now. Make it a habit to “pay yourself first.” Even saving $50/month at the moment you get paid starts a positive habit. As your budget allows, increase your habitual savings. Over the course of a few years, you can build up to a strong savings rate.
Question 3 – What should I invest in?
Again, this question will depend on you. In general, I suggest you focus on what you can control. You can control fees. You can control how long your money is invested. What you cannot control is how the stock or bond or real estate market performs over time. For accounts invested in the markets, I generally suggest you own low fee, passively managed, highly diversified funds. Many custodians offer “Target date” funds which automatically shift your investment allocation from stocks to bonds over time. As long as the expense fees are low, these are great options.
For do-it-yourselfers, Vanguard and Betterment offer good options. For those who would wish to partner with a financial advisor, pick one who is a fiduciary to you. You should want an advisor who works for your best interest, rather than his/her own. For a “why a fiduciary?” see reference  below.
You have reached the end of this blogpost. You win an imaginary gold star titled “i * Au.” If you would like to read more financial planning stuff written by John, you can click on this TrailFP main blog page. There you can search for blogposts based on specific financial planning topics. Thanks for reading!
 – For a detailed description of loans on 401k accounts, see Nerd’s Eye View (Michael Kitces’ blog): How the 401k loan works and should you use it?.
 – Why should you engage a fiduciary? John Oliver made a very entertaining 20-minute video that sums it up well.