2017 update: See our new post about investing money in retirement accounts vs. saving cash. We’ve also made some updates below.
Something I’ve been thinking a lot about since I read it is this Mint article on “The Value of Tax-Deferred Savings.” According to the article, “[u]nless you make enough money to max out all of your tax-advantaged accounts (401(k), IRA, 529, HSA, and the like), it rarely makes sense to do any investing outside them.” (Please note, I am not a financial adviser — this is all just my personal knowledge, so take it with a grain of salt.) (Pictured: Marc by Marc Jacobs – Turnlock Shine Long Tri-fold (Electric Teal) – Bags and Luggage, on sale at Zappos from $198 down to $150 today. Lots of great sales on Marc by Marc Jacobs stuff on Zappos today, actually.)
To be honest, the value of tax-deferred investing isn’t something I understood until really, really recently. So I thought we’d review some of the main vehicles for tax-savvy savings here, answering — for each, the main questions on everyone’s mind:
- What’s the advantage?
- How much can you put into it?
- Who can use it?
- Can you use it to put a downpayment on a house, or pay for something else big (wedding, car, schooling, etc)?
- When can you take it out?
Oh, and all of these vehicles aren’t the “end” of the story; you still have to figure out what fund or bond or stock you want your money to go into once it’s into that tax-deferred account. If you don’t have time to research the different options, here’s my tip: Look for a “lifecycle” fund, such as a “Retire in 2040” or “Retire in 2050” fund — the idea is that the fund manager reallocates the fund over time, so right now it’ll be heavy in aggressive investments like stocks, whereas when you’re closer to retirement they’re in safer investments like bonds. (N.B., though: I have heard that you have to really pay attention to these when you get closer to retirement to make sure they’re conservative enough for your blood.)
Where possible, I’ve linked to different articles written in plain English to back up my assertions; I’ve also linked to the non-fun IRS pages. Oh, and note that all of these deal with earned income only — so, for example, you can’t open an IRA in your child’s name and gift him $5K to put into it every year (unless s/he has somehow earned the money — child modeling, anyone?). And one other note: Can I just say I am stunned at how hard it was to “source” this article — for example, MyMoney.gov has a whole page on “saving for retirement” with “helpful” advice such as “don’t eat out a lot,” but next to no information on IRAs. Thanks, government!
- What’s the tax advantage? Money goes in before it is taxed, and grows tax-free. Even though the money will be taxed when you take it out, the idea is that your tax rate will be much lower when you are at retirement age. Furthermore, because it grows tax-free, you’ll save thousands of dollars over the long run. Very noteworthy bonus: many employers “match” — if you put in $3,000, they put in $3,000. Everyone agrees that if you don’t at least contribute up to the match, you are throwing away free money. That said, I have never had the pleasure of working for an employer who matched.
- How much? If you’re under 50, as of 2012 the maximum you can contribute every year is $17,000. [2017 update: $18,000.]
- Who? You have to contribute to your 401K through your employer — so if you aren’t a permanent employee, you’re out of luck.
- Can you use it to put a downpayment on a house? No. This is the big drawback to 401Ks — instead of being able to use the money for something right now (house, wedding, car, school), it is Retirement Money and you can’t take it out without a penalty (see below). Sometimes you can take a 401K loan out, but that can be tricky.
- When can you take it out? Age 59½. If you take it out before age 59½, you will pay income tax as well as an additional 10% early distribution penalty tax (although there are some fun exceptions, such as disability or death).
- What’s the tax advantage? The money you put into a Roth IRA comes after it’s already been taxed — but you don’t pay taxes on it once you withdraw it. Furthermore, the money grows tax-free over the years. Technically, this is tax-exempt saving rather than tax-deferred saving.
- How much? You can put $5,000 into a Roth IRA and/or a traditional IRA every year. [2017 update: $5,500.]
- Who? You can only contribute to a Roth IRA if your modified adjusted gross income is below $125,000 (for singletons) or $183,000 if you’re married and filing jointly. (See also.) [2017 update: $133,000 and $194,000, respectively.] Note that unlike other vehicles, there are no mandatory withdrawals at age 70.5 — and you can continue contributing to it for as long as you are working.
- Can you use it to put a downpayment on a house? After you’ve held the account for 5 years, you can withdraw up to $10K without penalty or tax for the purchase a first home. (See also.) As readers have noted, you can always withdraw principal without penalty (just not earnings).
- When can you take it out? While there are some exceptions (such as first-time home buyer, significant unreimbursed medical expenses, etc.), the normal age at which you can take out earnings (vs. principal) is 59½.
- What’s the tax advantage? Like a 401K, money placed in these accounts grow tax-deferred.
- How much? For 2012, you can contribute up to $5K annually. [2017 update: $5,500.]
- Who? You can contribute to a traditional IRA even if you participate in an employer-sponsored 401K. Note, however, that if you or your spouse is covered by an employer retirement plan such as a 401K, that will affect how much of your contribution is tax-deductible. Depending on your income, you may only be able to take a partial deduction or none at all.
- Can you use it to put a downpayment on a house? You can withdraw $10K for the purchase of a first home without paying the 10% penalty tax.
- When can you take it out? 59½, generally. If you are under age 59½, you must pay a 10% additional tax on the distribution of any assets (in addition to any regular income tax) unless you meet some of the exceptions, such as for higher education, certain medical expenses, or the purchase of a first home ($10K limit).
I’ll take a look at other investment vehicles (such as 529s and HSAs) in a later post (update: Part II is here). Oh, and Motley Fool has information on the “back-door Roth” strategy, noting that if you make too much for a Roth IRA but have the cash to save, you can open a traditional IRA and then go to the trouble of converting it to a Roth, where it can grow tax-free.
Readers, how much are you saving for retirement each year (versus saving for specific events such as a wedding or the purchase of your first home), and which of these vehicles are your favorites?