Beginning Baby step 4 (Funding retirement accounts) can be exciting for anyone who has emerged victoriously from their suffocating debt pile. A common phrase is often shared among our Baby step 4 clients once they breathe a deep sigh of relief: “What now?” Besides the obvious next steps, meeting with a financial advisor, creating a financial plan, and opening retirement accounts, there can sometimes be confusion surrounding the topic of funding those accounts. In this article, we will examine some of the options and which ones are appropriate, and when.
Once you’ve paid down debt, it’s time to start investing 15% of your income in retirement accounts. Whether you work for a company that offers a 401(k), or you’re a government employee and take advantage of the TSP, it’s important to know whether your employer offers a matching contribution. If they do, then we recommend contributing up to that amount, maximizing your exposure to “free money.” Not every workplace plan offers a match, so don’t just assume either way. Do the proper research and determine what is available to you. Depending on the plan, there may be a vesting schedule with the matching contribution, so be careful. If you don’t plan to be with an employer long-term, then it might backfire if your money isn’t fully vested and you terminate employment. All things considered, employer plans are generally a good opportunity to begin funding your retirement, so make sure you take advantage of the opportunity if it exists.
Roth Until You Can’t
Once you’ve met your matching employer contribution, the next thing to do would be to max out a Roth IRA. Starting in 2023 the contribution limit is $6,500 for an IRA. If you file taxes as an individual, or head of household, the maximum modified adjusted gross income (MAGI) for a full contribution is $138,000, and contributions phase out at $153,000. For married couples filing jointly the MAGI limit is $218,000 with a $228,000 phaseout. If you think there is a chance that your income will bump into the ceiling, then a Roth might not be for you. If your income exceeds the respective threshold and you make Roth contributions then you will be subject to a 6% excise penalty each year the funds remain in the account. If you know your income will be within the permissible range, then a Roth IRA allows you to take advantage of tax-free growth. That could turn out pretty nicely for you when you start taking tax-free distributions in retirement. Contributions to a qualified plan can help lower your MAGI if you’re on the cusp and hoping to contribute to a Roth IRA.
If you exceed the income limits for the Roth IRA, then a traditional IRA is your next best bet. The same $6,500 contribution limit exists, but the income limit does not apply here. A traditional IRA is pre-tax, so your earnings grow tax-deferred. When you take distributions in retirement, you’ll pay at your tax rate at the time of distribution. There is a silver lining to a traditional IRA, however. Since the contributions are tax-deferred, you may be entitled to some tax deductions during the year of your traditional IRA contributions.
If you can put away more than 15% of your income for retirement, then the next move for you would be to go back to your employer plan once you’ve hit the maximum on a Traditional or Roth IRA. The 2023 limit for elective deferral plans is $22,500. This higher limit allows you to contribute more toward retirement, but it comes with a cost, perhaps. The investment options might be somewhat limited on these plans, which is another reason we recommend maxing out an IRA if at all possible before going back to the employer plan.
A Taxable brokerage account is another option for those who want to retire early. Since you can’t draw money from an IRA before the age of 59 ½ you would need another source of income in early retirement. Dave Ramsey calls this a bridge account because it bridges the gap between early retirement and that magic number of 59 ½.
Retirement planning has many moving pieces and every situation is different, which is why it is important that you talk with a financial professional about your objectives. At Whitaker-Myers, we have a team of advisors who utilize sound financial planning as part of our comprehensive approach to serving our clients. Reach out today to schedule a meeting and begin planning your future.
WHERE TO FOCUS YOUR RETIREMENT PLANNING
December 22, 2022
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