This is not a post for someone who has never invested in anything. If that’s you, it’s time to start. Pick something easy like your work 401k or a Roth IRA. This post is for those who are trying to build wealth while minimizing taxes and fees.It also assumes that you have access to more than one type of retirement account and are eligible to have a health savings account. If that’s you, today I want to examine whether it’s better to invest in a 401k, Roth IRA, or HSA.
While, ideally, we’d max out all those accounts ever year, realistically, many people have to choose where to put their money. All of that depends on your age, tax bracket, and how much you have to invest.
The 401k is maybe the easiest of the three. Generally, if you work for an employer who has a retirement plan, you’ll fill out enrollment forms, select which fund you want, and determine how much to contribute, up to $17,500 a year if you’re under age 50. People over 50 can add an additional $5500 per year in 2014.
Even if you are self employed, you can still contribute to a solo 401k or SEP IRA. With these plans, you can contribute 25% of your compensation, up to $52,000 this year. The solo 401k has the added benefit of allowing an additional $17,500 if under age 50 or $23,000 if older than 50. That’s a lot of money that can be socked away!
With a 401k or SEP IRA, your contributions are pre-tax, so the more you contribute, the less taxes you pay per year. The money grows, tax free, until you start taking distributions. If you wait until age 59.5, then you only have to pay regular income tax on what you withdraw. If you take money out before that age, you’ll get hit with the income tax plus a 10% penalty.
I love 401k’s because my tax rate is pretty high right now. When I retire, I don’t expect to be in such a high tax bracket, although you never can count on tax rates many years down the road.
With a Roth IRA, money you contribute is after tax, but it grows tax free after it’s invested. You never have to pay taxes on the interest if you wait until age 59.5 to take withdrawals. I love Roths because you can withdraw contributions at any time without a penalty, just not the interest. I would not think of a Roth as an emergency fund, but money can be pulled out if things become dire. (No, needing a new bath remodel is not dire!)
You can only contribute to a Roth IRA if you income is below $191,000 for 2014. There are ways to do a backdoor Roth if your income is over that amount, but that’s for another post.
Roth IRA’s are a smart choice if you are in a very low tax bracket and believe it will be higher when you retire. A Roth IRA is also a good way to get started if your employer does not offer a 401k.
Health Savings Accounts
I love health savings accounts because they are triple tax advantaged. You can contribute pre-tax, money grows tax free, and if you use it for qualified medical expenses, you never have to pay taxes on withdrawals. If you are healthy and don’t need HSA funds for medical expenses, they can become a regular retirement account at age 65. At age 65, HSA money is subject to income taxes if used for non-medical reasons. Under age 65, there is a 10% penalty plus income tax if the money is used for non-approved expenses.
To have a HSA, you have to have an eligible insurance plan, which has gotten harder to find since Obamacare. If you are lucky enough to have one, you can invest in a variety of options. I currently have mine invested in Vanguard funds and don’t plan on touching a penny until I retire. That way, I have a shot at covering medical costs as I get older without having to consider costly long term care insurance. If I do have a train wreck medical emergency, I could pull money out without penalty.
Which Is The Best Retirement Account?
I think any way you contribute is the right way as long as you understand what’s best for your long term strategy.
In my case, I have a solo 401k through Vanguard that has tons of low cost options. Your work 401 k might not have good fund choices or high fees. In that case, I’d contribute enough to get any match, then look elsewhere. If the funds are good and fees are low, I’d contribute as much as I could to the 401 k.
Then, I would highly consider maxing out a HSA every year IF you have one AND are investing in something with a decent return. Besides the great tax benefits now, you could potentially never have to pay tax on that money. If you are putting it into a savings account with a very low interest rate, I’d only deposit money to cover current medical expenses.
For me personally, the Roth will be the last thing I contribute to this year if at all. With our tax bracket, it just doesn’t make sense unless we have maxed out everything else. If you are in a low tax bracket and your 401k choices are poor, I’d max this one out every time. If you max it out and still have money to contribute, go back to the 401k option.
Since we are all in different situations, there is no best answer, but hopefully sharing my strategy will encourage you to figure out and maximize yours.
Which type of retirement account is best for you at this point? Are you taking advantage of all the tax savings you can?