One of the best ways to boost your returns over time is to invest in a tax advantaged retirement account. With a tax advantaged retirement account, you get the benefit of investing with pre-tax dollars (for a traditional account). This means that you can boost the amount of money that goes into your account, helping your overall earnings over the life of your portfolio. Using a tax advantaged retirement like an IRA or 401k can help you improve your financial future.
It’s even possible to have both of these types of accounts. For 2013, the contribution limit for a 401k is $17,500 and the IRA contribution limit is $5,500. (If you are 50 and older, you can make a catch up contribution of $5,500 to your 401k and a $1,000 extra contribution to your IRA.)
If you have both of these accounts, which should you fund first? The answer depends on your own individual situation.
If your 401k comes with an employer match, then it makes sense to start with your 401k. Fund your 401k first, up to the point where you can get your employer match.
The employer match is desirable because it represents money that is basically free. Your employer will put money toward your retirement, matching your efforts up to a certain point. Do what you can to get the maximum amount available. This will allow you to build your nest egg faster.
Once you have met the requirements for your employer match, it’s time to look at your situation, and decide what to do next.
Does the 401k plan offered by your employer provide you with a variety of investment options? Can you pick from low-cost funds that allow you to diversify your portfolio? If your investment options are limited, now is the time to begin investing in your IRA. Open an IRA so that you can pick from investment options that appeal to you.
Realize, too, that if you have the stomach for risk, you can use a self-directed IRA to include some unusual investments, such as certain gold and silver coins and oil and gas royalties. If you adhere to the right requirements, it’s possible to hold real estate in an IRA.
Consider your long-term financial goals, and the investments you want to use to meet them. If you can’t hold the investments you want in your 401k, open an IRA and invest there.
Another consideration is the fees you are paying. Some plans come with fees of up to 4% a year. This can be a difficult situation, since the fees you pay erode your wealth. Instead of paying high fees, you can invest in an IRA with low-cost funds and not worry about fees. You’ll get more bang for your investment buck if you can reduce fees.
If you max out your employer match, then max out your IRA, it can make sense to return to your 401k. Another option, though, is to forgo your high-cost 401k and instead invest in tax-efficient assets with a taxable account. Tax-efficient investments like municipal bonds (if appropriate to your situation) can be a good way to make a little more use of your money without dealing with high fees.
As you decide where to invest first, don’t forget aspects of tax planning. Perhaps you don’t want to invest in tax-deferred retirement accounts; maybe you prefer accounts that grow tax-free. This means that you might want to consider a Roth IRA or Roth 401k (if offered by your employer).
Don’t forget about the tax consequences associated with your investment choices. If you invest in a tax-deferred account, you will have to eventually pay taxes when you begin taking contributions. Roth retirement accounts allow you tax-free withdrawals.
Consult with a knowledgeable retirement planning and tax planning expert to help you work out an investment strategy that allows you to determine the best course of action for your situation.
What do you think? Where do you invest first?
Photo credit: Andreas Kollegger.