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With the goal of minimizing annual taxes, many people put almost all of their savings into a 401(k), IRA or other tax deferred retirement plan. Conventional wisdom is that you should always save as much as possible in tax deferred accounts.
Unfortunately, this approach may be very costly if a financial emergency occurs or if tax deferred funds are needed for your children’s college expenses. Here are some tips that may help when deciding where to put your savings:
- If your company offers a company match on their 401(k) or 403(b) plan, always save up to the company match limit. Whether the company match is 50 percent or 100 percent of your contribution, take the “free money” offered by the plan. If your company’s contribution is their own corporate stock, invest the remainder into a well diversified portfolio with no company stock. When the company’s stock contribution may be exchanged, sell the company stock and put these funds into the diversified portfolio. A one word reminder of why this is important is “Enron.”
- An emergency fund, available to cover at least six months of expenses, is the next savings priority. Forgo a tax deferral on an IRA or additional 401(k) contributions until these funds are in place.
- Roth IRA contributions are extremely flexible. While Roth IRA contributions are not tax deductible, all contributions to a Roth IRA can be withdrawn at any time without any taxes or penalty. If $20,000 has been contributed to a Roth IRA over a four year period and the Roth IRA is now worth $25,000, $20,000 may be withdrawn with no taxes or penalties, regardless of your age.
- IRAs provide more investment flexibility and typically have lower fees than 401(k) or 403(b) plans. Assuming an emergency fund in place, after contributing to the company matching limit with a 401(k) plan, additional savings could be used to fund a traditional IRA. This approach is only available to a married, jointly filing tax payer with income below $92,000. If income is above $92,000 but below $173,000 a Roth contribution might be appropriate.
- A married, jointly filing tax payer, who does not participate in an employer’s retirement plan but whose spouse does, may make a fully deductible contribution to an IRA if joint income is below $173,000 in 2012.
- Whether or not a married, jointly filing tax payer is covered by a company retirement plan, an annual $5,000 ($6,000 if over age 50) contribution to a Roth IRA is available if income is below $173,000.
- Be cautious of Stable Value funds. With the market volatility of the past few years, many people in 401(k) or 403(b) plans have found refuge in stable value funds. One should exercise caution with these funds as they often have restrictions on your ability to reallocate money placed in these funds
A major 401(k)/403(b) plan sponsor is TIAA-CREF. The traditional TIAA plan is a Stable Value fund with a guaranteed a rate of return that changes annually. Funds invested in the traditional TIAA Stable Value fund, are similar to entering “Hotel California.” Once they are deposited in this Stable Value fund, they may only be removed over a 10-year period. The maximum yearly withdrawal from a TIAA traditional fund is limited to 10 percent of the funds available. Since market conditions and personal financial conditions may change, be very cautious when considering placing a significant amount of retirement plan funding into what may effectively be an illiquid investment, if the funds are required within ten years.
Due to the many restrictions, contribution limits and penalties associated with tax deferred retirement plans, it is important to carefully consider your savings alternatives. Working with a qualified financial adviser who, as your fiduciary, always places your interests first, develop a strategy that both minimizes taxes and provides for penalty free funds that may be required before your retirement years.