Retirement Account Strategies
Posted by: Joseph Kuo | June 12, 2021
With cryptocurrency and the latest hot tech companies offering the tantalizing chance of a quick and enormous return on investment, It’s natural to ask: Why should I even bother with a retirement account if I can make more money through my regular after-tax investment account?
If you’re an experienced investor, retirement accounts such as 401(k) or Individual Retirement Accounts (IRAs) might not seem all that worthwhile. The typical 401(k) plan limits you to several very general options, categorized by type of investment and approximate risk level. Individual Investment Accounts (IRAs) do allow you to invest in most securities, but are limited in the amount you can contribute annually.
Once you’ve placed your money in a 401(k) or IRA, you won’t be able to make withdrawals until retirement age. There are certain exceptions for hardship, education expenses, and first time home purchases, but otherwise, if you withdraw before age 59 ½, you will pay a 10% penalty plus the taxes on the added ordinary income of the withdrawal itself.
So with these initial restrictions in mind, when should I even consider a retirement account? Here are a few possibilities.
Company Matches Your 401(k) Retirement Account Contributions
This is the easiest scenario. If your employer offers a match or defined contribution to a 401(k), that is free money for you. Unless you immediately need the funds you would be contributing, and have absolutely no other alternatives, take the match. There are no investments out there that automatically double what you put in on day 1. It’s the easiest investment decision you can make.
Retirement Accounts Can Mitigate and Defer Taxes
You can use retirement accounts as a tool to give you more options to spread out and possibly reduce your overall tax burden. First of all, a retirement account can help you defer taxes on the amount deposited. For a 401(k) account, this amount is $19500 (and an additional $6500 if you are over 50). If you have an IRA*, the amounts are $6000 and an additional $1000 respectively. (All figures are for the 2021 tax year).
You can use the different types of retirement accounts to manage when you pay your taxes to take advantage of the lowest tax rate possible. Roth 401(k)/IRAs** let you pay your taxes now, and are not taxed when you withdraw the funds in retirement. If you are anticipating your income (and thus, tax rate) to continue to increase up to retirement, you might want to consider a Roth account to lock in a portion of your funds at the lower tax rate on your present earnings. Conversely, a Traditional 401(k)/IRA will let you defer taxes on the portion deposited until retirement, when you may be in a much lower tax bracket. While future tax rates could change by the time you retire, it’s at least a way to kick part of the tax can down the road.
Use a Retirement Account to Auto-Manage Part of your Portfolio
Investment markets can be very volatile, with swings of 20% and above in a year, especially if you are seeking high rates of return. The higher potential rate of return on the investment, the greater the risk and the wilder the swings. The more volatile the investments, the more hands on management is needed.
Almost all retirement accounts allow you to automate certain management functions such as rebalancing. With the demands of work and family, you might not always have the time to monitor current investments. If “real life” intervenes, having a retirement account can put at least a portion of your assets under a more managed umbrella.
Ideally, if you have a financial planner, the planner can not only develop a plan on how best to invest your funds to meet your goals, but also monitor and manage your portfolio for you to make sure the plan is being implemented.
A properly managed retirement account can provide you with a foundation of investment assets that will be relatively safe. With this foundation, you can invest in the current market knowing you have a backup stream of income, and that your future retirement security is not completely dependent on how well you invest in the current market.
So What Should I Do?
Are retirement accounts worth it for me? If so, should I go with a 401(k) or an IRA? Roth IRA or Traditional?
An experienced financial planner will help you find the right answers depending on your own situation and put together a customized plan for you that will get you the maximum benefit for your investment portfolio.
*There is an income limitation beyond which you will not have income tax deduction for your IRA contribution. However, even then, the earnings and growth of your investments will be tax deferred until you withdraw from your IRA. Also, your after-tax contributions will not be taxed again when you withdraw.
** There is an income limitation beyond which you cannot contribute to a Roth IRA. However, there are ways around this. Consult with your financial advisor on how and if it makes sense for you to do this.