What are the best strategies to use to save for retirement? In this video and in the summary below, I respond to a few questions sent to me regarding the “right” ways to save for retirement. Specifically, we discuss these three questions:
- Presuming that a 401(k) alone won’t be sufficient to fund your retirement, what are the “next best” places to put your retirement money?
- Pre-tax vs. Roth retirement accounts- what’s the best option to choose?
- How much do you really need to save for retirement?
(Bill’s Note: The video below was originally recorded as a Facebook Live broadcast on November 26, 2018.)
The Three Tiers of Retirement Savings
Not all retirement savings accounts are created equal. If your goal is to save aggressively for retirement, you’ll likely need to make some decisions about where you should be putting your money for retirement.
I like to think about retirement savings accounts in the context of three different “tiers” that you should contribute to, in the following order:
Tier 1: Employer-Sponsored Retirement Accounts
If you have access to a retirement plan through your work, this should almost always be your first priority to save for retirement. Typically, these accounts are structured as 401(k) accounts (for private sector workers), 403(b) accounts (for non-profit and education workers), or 457 accounts (for government employees).
If you don’t have access to a 401(k), 403(b), or 457 account through your work, you should skip to Tier 2, with one caveat. If you are self-employed, there are a myriad of other retirement account options you could set up. We’ll discuss these in more detail another day.
Assuming you do have a 401(k) or similar account at your job, there are several things you should consider:
- If your employer matches your contributions, you should, at a minimum, contribute enough to receive the full match. This is the closest thing to “free money” that you’ll ever get, so take advantage of it!
- One of my favorite strategies to help people find ways to save more for retirement is to increase your 401(k) contributions by 1% every time you get a raise at work. You won’t notice the money you’re “missing” from your paycheck, since your paycheck is going up, anyway! But you’d be surprised how big an effect thee gradual changes can have. By the time I left my corporate job at PwC before starting my own business, I was contributing 12% of my paycheck to my 401(k), simply by following this strategy.
- Most employer-sponsored retirement accounts are pre-tax accounts. In other words, you don’t pay income tax on the money you contribute to these accounts (and in return, the money will be taxed when you withdraw funds from these accounts during retirement). But “Roth-style” 401(k) plans have become increasingly common in recent years, which work the exact opposite way- you pay income taxes on your contributions today, but can withdraw the money tax free in retirement. If you have access to a Roth 401(k), you should seriously consider utilizing it. More on Roth accounts in a bit.
- Finally, make sure you know the maximum contribution you’re allowed to make to your retirement accounts every year. For 2019, the max you can contribute is $19,000 per year (assuming you’re under the age of 50). Typically, the IRS raises this limit each year (it was $18,500 in 2018, for example.)
But, as the three questions at the beginning of this post strongly implied, 401(k) savings alone typically aren’t sufficient to completely fund your retirement. So, after setting up your 401(k) contributions, what should your next step be?
Tier 2: Individual Tax-Advantaged Accounts
As you have probably noticed, a key component of optimal retirement savings strategies includes managing taxes on your investments and retirement income. As a result, you should always look for tax advantages in your retirement savings strategies, whether they’re traditional accounts (no taxes now, but you pay taxes during retirement) or Roth accounts (pay income taxes now, grow and withdraw the funds tax free in retirement).
There are several different options available to you in Tier 2. And my favorite one might surprise you.
Health Savings Accounts (HSAs)
Outside of a 401(k)/403(b)/457, HSAs are my absolute favorite way to save for retirement.
Why? Because HSAs are essentially the last complete tax shelter that exists in America.
When choosing between a Traditional or Roth IRA, you pay taxes on your contributions at some point; whether it’s today or during retirement, your money gets taxed eventually.
But as long as you use the funds in your HSA for qualifying medical expenses, the money you contribute and invest in an HSA is never taxed. Presuming your HSA account allows you to invest the money in your account, this can be an incredible savings vehicle for retirement.
This probably isn’t a shocker for you, but one of the primary challenges in preparing for retirement is making sure you have enough cash on hand to support your medical bills as you get older. With the rising cost of medical care, using an HSA to save for these retirement expenses is an incredibly efficient way to prepare for this.
Of course, there are a few qualifiers here:
- You’re only eligible to open and fund an HSA if you have a high-deductible health plan. And if you do, you need to make sure you have a sufficient emergency fund to meet your deductible if you want to use your HSA for long-term investing.
- The maximum contributions you can make to an HSA are relatively low.
HSAs are commonly overlooked as a retirement savings vehicle… but they really shouldn’t be.
NOTE: HSAs and Flexible Spending Accounts (FSAs) are not the same thing. You should not be using FSAs to save for retirement, because you need to use the money in FSAs each year or it goes away. Conversely, you are allowed to accumulate money in an HSA.
Traditional/ Roth IRAs
In 2019, you can contribute $6,000 to either a traditional or Roth IRA (up from $5,500 in 2018). Although, it’s worth noting that you have until April 15, 2019 to make that $5,500 contribution to your IRA for the 2018 tax year!
There are several questions you need to answer to determine which is the right type of account to use. Here’s how to decide which one to contribute to:
Can you deduct a traditional IRA contribution? We’ve already established that “traditional” retirement accounts allow you to deduct your contributions from your taxable income this year. But here’s the catch: if you have a 401(k) or similar account at work, you likely can’t deduct your IRA contribution on top of that. The rules are somewhat complicated, and you should seek professional advice to verify your ability to deduct your IRA contributions. But, this should be the first question you answer before making your decision.
Are you eligible to contribute to a Roth IRA? “Making too much money” is generally a good problem to have. But, it can make you ineligible to directly contribute to a Roth IRA. The table below shows the income restrictions on making direct Roth IRA contributions.
Two caveats about this:
- These income restrictions do not apply to Roth 401(k) plans. So, if your employer offers one, it is worth considering regardless of your income levels.
- You technically can still get money into a Roth IRA utilizing a Roth IRA conversion strategy. This is a very complicated process and it’s important to make sure you do it the proper way to avoid trouble with the IRS, so you should seek professional help before attempting this on your own.
When will your tax rate be higher: now, or during retirement? This is the fundamental driver of the Traditional-or-Roth IRA decision. Simply put, you want to pay taxes when you’re in a lower tax bracket.
If you expect your tax rate to be higher in retirement than it is now, you should pay taxes on your income now and withdraw it tax free in retirement by using a Roth IRA. If, on the other hand, you expect your income (and income tax rate) to be significantly lower when you retire, a Traditional IRA is probably the right choice for you.
However, this is more complicated than it appears at first glance. Remember, we’re not looking to compare your tax rate today with what your tax rate today is for your expected retirement income level. You need to think about how tax rates will change between now and when you retire to make this decision. Which, given that your retirement date is likely decades from now, is notan easy task.
My personal belief? Particularly after the passage of the Tax Cuts and Jobs Act in late 2017, today’s income tax rates are at all-time lows. Which makes me inclined to believe that tax rates are likely to be higher when we retire, making Roth IRAs a great option for young people today. That’s just my opinion, of course; I don’t have any more of a crystal ball to predict the future than you do. But, particularly if you’re close to exceeding the income limits, you should seriously consider a Roth IRA.
How much flexibility do you need? One final thing to consider: Roth IRAs are much more flexible than traditional IRAs. While I don’t typically recommend that you withdraw money from your retirement accounts before retirement, you should know that you can withdraw your contributions to your Roth IRA at any time, without penalty. (As long as your investments haven’t gone down significantly in value of course- you can’t withdraw something that isn’t there!) You can’t withdraw the investment earnings in your Roth IRA without paying a significant penalty, but you canwithdraw your contributions.
Make Non-Deductible Contributions to Traditional IRAs
Even if you can’t deduct your traditional IRA contributions, it’s a strategy worth considering.
Even though you won’t be able to deduct a $6,000 (2019 maximum) contribution to a Traditional IRA now, and you’ll pay taxes when you withdraw the money in retirement, there’s still one tax benefit you can take advantage of: between now and when you retire, you won’t be taxed each year on the investment earnings in your account.
You might be losing the “primary” benefit of a traditional IRA if you can’t deduct the contributions, but at least you’ll save on taxes every year between now and when you retire by sheltering your investments in this type of account.
Tier 3: Regular Investment Accounts
You should be investing your retirement savings into something. Which means that once you’ve run out of retirement account options, your final option is to invest in a regular brokerage account.
There are no tax benefits to holding this type of account. The money you put into this account is after-tax money, your investment earnings will be taxed every year, and you’ll be taxed when you sell your investments. But, the primary challenge in saving for retirement is making sure your money grows at a faster rate than inflation. By investing your money as opposed to keeping it in a savings account, you give yourself the best possible shot to make sure that happens, even if there aren’t specific tax benefits for doing so.
What Shouldn’t You Use to Save for Retirement?
In a nutshell: you shouldn’t use permanent life insurance or annuity products to save for retirement.
I’ve written at length before about why I hate permanent life insurance as an investment vehicle for retirement. It might come with tax benefits, but the costs of these products far outweigh the benefits for the vast majority of people.
And for young people, annuities are even worse. Until you’re at least 50 years old, you shouldn’t even consider purchasing an annuity. And even then, there are still probably better options for you.
I’ll probably do a whole separate article about why I dislike these products. But until then, if you’re contemplating using life insurance or annuities as a retirement-savings vehicle, you should seek advice from a third party who doesn’t sell these products for a livingto make sure it’s the right fit for you.
How Much Do I Need to Save For Retirement?
Unfortunately, there’s no generic answer I can give to this question. Everybody’s retirement savings needs are different, so you should work with a financial planner to develop a retirement plan specific to you and your vision for your life to answer this question.
Simply put, the way you want to live in retirement significantly impacts the math on how much you need to save. Consider two different families: one of whom wants to purchase a vacation house on the beach when they retire, and the other wants to sell their primary house, downsize to an apartment, and buy an RV to travel the country.
Which person will need more money to support their vision for their life in retirement? All other things equal, the first one.
You need to develop your own retirement savings plan to determine how much you need to save. If you want to learn more and get this process started, I encourage you to book a free breakthrough session with me so we can discuss more and start developing your plan of action.