When it comes to putting aside savings, ask yourself the following questions:
- What are you saving for?
- When do you plan to use the money?
It can be difficult to save money when you’re first starting your career. That said, I always recommend saving at least 15% of your gross income into retirement for the outset. This will allow you to retire in your mid 60’s comfortably and not have to worry about a decreased lifestyle in retirement.
As time goes on and your career progresses you should maintain this savings rate. If you start late or fall behind you will have to increase your savings rate to achieve similar results. It becomes much more difficult to achieve a successful outcome the longer you wait.
This is simply due to the fact that you don’t have the same amount of time on your side. The market has tended to reward long-term investors so you’re doing yourself a disservice if you’re not being consistent with a savings and investment plan.
Your savings rate is the first step in creating an investment plan. Once you have this amount in mind you can figure out which accounts to use for your situation. As I previously mentioned, I’m going to focus on two common retirement savings methods: a Roth IRA and investment accounts.
That said, I’d like to mention that you should always be contributing to any employer plans that offer a matching component. This applies to 401(k)s, 403(b)s, and SIMPLE IRAs for example. You should be contributing up to capture the full matching percentage of your employer. Otherwise, you’re leaving money on the table. Curious about contribution limits? Check out my post on 401(k)s.
The Purpose of A Roth IRA
Once you’re contributing up to the match in your employer plan you should do your best to max out a Roth IRA on an annual basis. As of 2021, you can contribute $6,000 if you’re under 50 or $7,000 if you’re over 50. The easiest way to accomplish this is to set up automatic monthly contributions that allow you to max out the account.
You can contribute to a Roth IRA for yourself as well as a spouse. This doubles the amount you can contribute as a household. IRAs are individual accounts so they must be opened in the name of the individual. They cannot be jointly titled. You want to take advantage of the annual contribution amounts since they’re a “use it or lose it” opportunity.
There are a few benefits of a Roth IRA:
- They’re funded with after-tax money. Therefore, the funds grow tax-free for the rest of your life. This means you’re not paying taxes on any income produced by the portfolio and you don’t have to worry about capital gains when selling appreciated securities.
- The funds are withdrawn tax-free. These are subject to early withdrawal rules but the idea is that once you’re retired they are taken out tax-free.
- You do have the ability to withdraw your contributions, or the amount you put in, tax and penalty free at ANY TIME. This can be a comforting benefit for some people to know that they can still get the money should something happen.
The purpose of a Roth IRA is to help you save money on a tax-free basis. If you know that you’re likely going to be in a higher tax bracket in retirement, then setting up a Roth IRA is a no-brainer. That said, it also helps with tax diversification since the future of tax legislation is unknown.
People usually have the majority of their assets tied up in pre-tax accounts so a Roth IRA can help accumulate after-tax assets to navigate changes in the tax code in retirement.
The Purpose of An Investment Account
An investment account is a taxable, or non-qualified, account that allows you to invest in the stock market. It’s a non-retirement account that can be opened up at most banks or custodians. There is no limit on the amount you can put in or pull out of the account. This gives you options for managing the money inside the account.
I still refer back to my initial questions when funding an investment account: What are you saving for and when do you plan to use the money? The timeline for the money will dictate the investment objective of the portfolio. The more time you have the more risk you can take on with the portfolio.
For the purposes of comparing an investment account to a Roth IRA, I will assume this is going to be used for retirement purposes. Unlike retirement accounts, the income coming from investments inside the account may be subject to income or capital gains taxes. This is a major drawback. As the account grows, these can be fairly large numbers.
To give you an idea, a portfolio may produce anywhere from 1% to 5% of income each year. If you have a million dollars this would be $10,000 on the low end or $50,000 on the high end that would be taxed as ordinary income or qualified dividends. Qualified dividends receive preferential tax treatment and are typically taxed at 0%, 15%, or 20% depending on your taxable income for the year.
Lastly, if you sell an appreciated asset you will be subject to capital gains tax. These will be short term or long term depending on if you’ve held them for one year or longer. If they are held for less than a year, they will be taxed at your ordinary income rates. If you’ve held them for longer than a year, they will be taxed at 0%, 15%, or 20% depending on your income.
The taxability issues discourage some people but you actually have some control over the outcome since capital gains won’t be triggered unless you sell something. A portfolio can be invested very tax-efficiently to where the majority of the income will be from qualified dividends, therefore it will receive preferential tax treatment. You can also place heavy income producing funds in retirement accounts to lower the tax bill.
Roth IRA vs. An Investment Account: How to use them both
Assuming both your Roth IRA and investment account are used for retirement you can manage them as a single portfolio. This will allow you to take advantage of the tax types of each account. As mentioned above, you can place bond funds and real estate into retirement accounts since they will not be taxed.
As you make more money throughout your career and you can save more for retirement you will max out your employer plans and IRAs fairly easily. Once this is done, you can contribute additionally to an investment account to build your retirement portfolio even more.
This way you’re not limited in how much you can save for retirement. The investment account also provides you with options should you need the funds for other goals in the future. This can be used to fund businesses, college, or a house down payment for example.
Final Note: Taxation Hedge
If you accumulate assets in all three types of accounts – pre-tax, after-tax, and taxable it will help you manage your tax bill during retirement. Depending on the tax code at that time it will dictate the distribution strategy of your retirement portfolio. Having all three types of assets will help you diversify and manage the legislation and taxation risk of your portfolio.