Individual Retirement Accounts (IRAs)

The Individual Retirement Account (IRA) is a widely know and frequently used vehicle to stow away for a later day and save taxes in the process. Do you regularly fund an IRA? Have you considered where this IRA fits in your overall personal financial life?

I have previously written about the contribution limits and the technical differences between a traditional IRA and a ROTH IRA, but today I want to zoom out and discuss whether someone should utilize an IRA in the first place.

Sequential Savings

The past few months I have walked through my sequential savings ladder. Nothing in personal finance is one size fits all but this is one way to think through the difficult question “where should I put my savings?” This question is impossible to properly answer without context and a review of each individual’s circumstances but not all savings vehicles are created equal and some are generally favored over others.

The first two steps are about getting set up. Looking at your liabilities and debt to come up with a plan to aggressively pay down high interest debt (credit cards and student loans) and manage other reasonable debt (auto and home). The emergency fund has two qualities: it’s boring and it’s important. Kidding aside, without an adequate backstop, a financial emergency could force early withdrawal from retirement accounts resulting is income tax, an early withdrawal penalty, investment losses, and surrendered future compounding.

The Health Savings Account is next for those with a High Deductible Health Plan. This account has four layers of tax savings compared to just two tax savings layers in the 401(k) or IRA. Plus, HSA funds can either be used for current medical expenses or left in the account and invested for long-term tax advantaged growth.

The 401(k) is very similar to the individual retirement account. So, let’s talk about the transition from #4 (401k) to #5 (IRA) in the sequence above.

401(k) or IRA?

The 401(k) and 403(b) have 2020 contribution limits of $19,500 for those under 50 years old and those 50 or older can contribute $26,000 during the year. Ideally, the goal would be to fully fund your 401(k) and then fully fund a back-door ROTH IRA. However, filling up both buckets would take $25,500 in annual available savings (or $33,000 for those 50 or older). So, if after establishing a debt paydown plan and fully funding your emergency fund and HSA you have less than $25,500 of savings to allocate toward retirement, should you allocate it all to your 401(k) or split the savings between your 401(k) and IRA? This decision revolves around a few items.

Investment Options and Fees

First, what type of investment options and fees are associated with the employer retirement plan? Some 401(k)s and 403(b)s have incredibly expensive investments which can significantly drag down your growth over a working career. Often times, an IRA through a major custodian (Schwab, TD Ameritrade, Fidelity) provides many more investment options at much lower costs than a workplace retirement plan. If you determine an IRA has lower cost, higher quality investment options why contribute to the 401(k) at all? The primary reason is the employer match.

Employer Match

What is your employer’s matching arrangement? My wife and I each have a workplace retirement plan. One plan matches 100% of the employee’s contributions up to 3% of their salary. So, a $150,000 salary is eligible for a $4,500 employer match as long as the employee defers at least $4,500 that year. This dollar for dollar match, up to 3% of compensation far outweighs any investment or fee drag in the 401(k). So, an employee in this scenario might consider taking full advantage of the match by contributing 3% of their salary each year and then any left over savings could be used to fund an IRA with lower cost higher quality investment options.

Flexibility

Those looking to fund the ROTH 401(k) or a ROTH IRA might desire flexibility. The ROTH IRA is an extremely flexible vehicle allowing for withdrawal of previous contributions at any time, tax and penalty free. The ROTH 401(k) is often bound by in-service withdrawal restrictions which means most employers will not allow employees to take distributions unless it is a hardship withdrawal, a loan, or due to termination of employment. However, the ROTH IRA does not have any withdrawal restrictions making it a much more flexible vehicle to access before retirement should you need to. 

Out of Sight Out of Mind

Some employees might be looking for the opposite of flexibility. If you have a tendency to dip into your savings account for current day discretionary expense you might prefer to have your retirement savings drafted from your paycheck and locked away in a 401(k) with little ability to withdrawal early. This scenario would favor the 401(k) over the IRA to protect those dollars from current day spending temptations.

Will and Katie

Will and Katie are married and have $17,000 each year to allocate toward retirement savings after coming up with a debt paydown plan and fully funding their emergency fund and HSA. Will and Katie both make $120,000 a year. Will’s employer will match 10% of his contributions up to 100% of his salary and Katie’s employer will match 100% of her contributions up to 3% of her salary. Will and Katie know they are self-controlled enough to not raid their 401(k) or IRA and are looking to maximize their growth opportunity and flexibility. Katie chooses to max out her employer match with a $3,600 401(k) contribution. Will decides to contribute $3,400 to his 401(k) which will result in a $340 match. Will feels the 10% match is not meaningful enough to pull in all of his savings. This leaves the family with $10,000 ($17,000 – $3,600 – $3,400) to allocate. Will and Katie each open IRAs and use the back-door ROTH strategy to each contribute $5,000 to a ROTH IRA providing them lower cost investment opportunities and flexible withdrawal ability for needs that could come up before retirement such as college tuition for their two kids.

Takeaways

Will and Katie are just a hypothetical scenario illustrating how you might think through funding your employer retirement plan or an IRA. The key things to consider are:

  • The investment options and associated fees in the employer retirement plan
  • The employer match available
  • Your desire for flexibility or a desired intentional lack of flexibility