When it comes to holding stocks or bonds or just about any other kind of investment, financial advisors are pretty much united in their advice: diversify, diversify, diversify.
"Don't put all your eggs in one basket" is a cliché for a reason. Different types of investments go up and down at different times for different reasons. By spreading your portfolio across a variety of investments, you theoretically decrease the chances that a steep drop-off in any single investment could affect you.
But what about the accounts that house your investments? Those come in different varieties, too, and the mix that you hold can affect how you can make use of your nest egg in retirement.
Some experts, such as IRAHelp.com publisher Ed Slott, are powerfully in favor of Roths. "One you have a Roth, you never go back," he says. "You end up saying to yourself, 'Why would I ever build in a taxable account?'"
Roth IRAs and Roth 401(k)s are far from your only good options, though. Here's an overview of what's available and what to consider when you're choosing.
Common forms of retirement saving fall into three buckets.
- Pre-tax accounts: Accounts such as traditional 401(k)s and IRAs are funded with money you have yet to pay taxes on. Contributions you make to these accounts are typically deducted from your taxable income in the year you make the contributions. For instance, if you earned $50,000 in 2021 and contributed $5,000 to your traditional 401(k), your taxable income drops to $45,000. In exchange for this upfront tax break, you'll owe income tax on any money you pull from these accounts in retirement, and if you withdraw before age 59½, you'll owe a 10% penalty as well. You must begin taking distributions from these accounts at age 72 if you were born July 1, 1949, or later.
- Roth accounts: Roth 401(k)s and Roth IRAs are funded with money you've already paid tax on, so you won't get an upfront deduction. Once you turn 59½, provided you've owned the account for five years, you can withdraw money from the account tax-free. With a Roth IRA, you can withdraw up to the amount you've contributed any time without paying a penalty.
- Taxable accounts: If you open an account with a brokerage, you can move money in and out without strings attached. But unlike accounts geared toward retirement savers, brokerage accounts are subject to capital gains tax if you sell investments for more than you paid for them, as well as levies on dividend and interest income.
It's important to have a solid financial foundation, such as a well-established emergency fund, before investing, experts generally caution. From there, they say, prioritize getting what advisors playfully refer to as "free money."
"Once you've got a budget and an emergency fund, and you're investing on Day 1, you should put enough in your 401(k) to get a company match," says Tim Sobolewski, a certified financial planner with the Financial Planning Center in Buffalo, NY.
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From there, you'd be wise to focus on building your Roth savings, whether it's through a Roth 401(k) account at your workplace or by opening a Roth IRA, says Slott.
"Everyone should be doing Roths, and for young people, they're a slam dunk," he says. "They should be capitalizing on the power of compounding in this tax-free way. Plus, it acts as a hedge against the uncertainty of what higher tax rates in the future could do to your savings."
If it were up to Slott, people who had the ability would put all of their retirement savings in Roth accounts. That's not always feasible: Not every workplace offers Roth 401(k) accounts, for example.
Roth IRAs, meanwhile, have low annual caps and are subject to income limits: Only individuals making less than $129,000 (or $204,000 for joint filers) can contribute the maximum of $6,000 in 2022.
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For people who have a significant portion of their savings in non-Roth accounts, Slott suggests converting to Roth accounts. "If you were about to retire, would you want all your savings in a big taxable basket?" he says. "You might want to think about diversifying your tax risk."
He notes that "tax-risk diversification is really only for people who have taxable accounts." That's because "you can't beat zero percent. If I have zero risk of future taxes, why would I diversify into taxable accounts?"
Still, some financial experts see the wisdom in funding different types of accounts. "I think it's a good idea to have all three," says Sobolewski. "You may find that in certain years, you can use an upfront deduction."
Depending on your plans, having some taxable dollars won't hurt either. For one thing, having money that isn't earmarked for retirement might make sense if you're saving for an intermediate-term goal, such as buying a house.
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It may also be a good option if you plan on retiring early, says Howard Hook, a CFP and certified public accountant with EKS Associates in Princeton, New Jersey.
"If a client retires before the age at which they'll collect Social Security and take required minimum distributions, they may need some money to make up for the income shortfall," he says. "Ultimately, capital gains rates are lower than ordinary income tax rates, and if you don't want to touch your IRA or Social Security, a taxable account can be a good way to bridge the gap."
If you reach a point in your career where you have enough extra income coming in to fund multiple accounts, it's probably a good idea, Hook adds.
"Having money in different types of buckets, with different kinds of ta characteristics gives you flexibility for when you need the money in retirement," he says. "Having options is always better. Don't pigeonhole yourself into having to do it one way or another."
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