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Q: My goal is to save 15% of my salary. I have a 401(k) plan at work. I also have a personal Roth IRA and taxable brokerage account. How should I prioritize my savings?
Building a Nest Egg
Dear Building a Nest Egg,
Your savings goals are admirable! Make sure you get any free or matching money, and then focus on tax efficiency.
Before you focus on retirement savings, I always like to make sure an emergency reserve account is funded. We all know people who have unexpectedly lost their jobs. So I recommend you put three to six months of living expenses into an account you could access quickly in the event of an emergency.
Your next priority should be retirement. If your employer offers a 401(k) match, start your savings here. At minimum, many employers match the first 3% of your savings. This is free money that you can‘t afford to pass up.
For those that income qualifies, typically the next best place to begin is by adding $5,000 in a Roth IRA. Income phaseouts for Roths begin at $105,000 (modified adjusted gross income, or MAGI) for single filers and $166,000 (MAGI) for joint filers. A Roth provides flexibility because you can access the principal at any time without penalty. Like a traditional IRA, a Roth allows your money to grow tax deferred. But unlike a traditional IRA where you will pay ordinary income tax when you begin distribution, Roth money comes out tax free. And with the income tax debate currently controlled by legislators advocating even higher rates, I don’t think you will regret having some tax free money.
Stash any remaining money and invest it in your taxable brokerage account. Following these steps will ensure your retirement egg is golden.
Q: I am a self-employed consultant with no employees. Do you suggest an individual 401(k) or a SEP IRA for my retirement savings?
Weighing My Options
Dear Weighing My Options,
The simplified employee pension (SEP) plan and individual 401(k) plan both are advantageous for self-employed business owners. But I typically recommend the individual 401(k). It‘s more flexible and carries a more powerful tax savings punch.
With both plans you can vary your contributions from year to year. But only the individual 401(k) (also known as a “solo 401(k) “) offers you the option to defer the first $16,500 of income. Despite the name, if your spouse also earns an income, double that savings to $33,000. And if you‘re 50 or older, add an extra $5,000. Unlike the SEP, which only allows tax–deductible savings, an individual 401(k) allows you to save this money in a traditional pre-tax or Roth after-tax account that comes out tax free in retirement.
Both the SEP and the solo 401(k) allow for contributions up to 20% of qualified income (for sole proprietors) or 25% of W-2 income (for corporations). That‘s a total reduction of taxable earnings of $49,000 for those younger than 50.
The difference is apparent when you look at a 40–year–old who has $100,000 of W-2 income. The SEP allows a deductible $25,000 contribution, whereas the individual 401(k) permits a much larger contribution of $41,500 ($25,000 + $16,500).
A SEP does not require the same annual reporting. But these days custodians like Charles Schwab provide this service without a fee. Additionally, the 401(k) has a loan provision, allowing employers to borrow from their accounts if necessary.