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Prioritizing Your Tax-Sheltered Retirement Accounts

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

It's Tax Relief Week on Today, we're talking about your tax-advantaged accounts and how you should think about sequencing your contributions to those accounts.

Here with me dig into the details is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, I think the place that we agreed you should start thinking about your tax-advantaged accounts is your 401(k) plan, because that's the one that has a lot of the benefits that you're getting with your employer, but if you're going to start there how do start to assess how much you want to put in that plan and whether that's going to be your sole investment option among the tax sheltered accounts?

Benz: This is a step people often miss, Jason. This is just conducting some basic due diligence on the quality of the 401(k) plan. Don't just rely on what your coworkers are saying about it. Get in there and do a little homework.

So, you do want to look at whether you're paying any administrative costs to the provider for putting this whole thing together for you. That extra layer of fees can really add up, so that's a red flag that you've got a costly and/or subpar plan.

Also do a little bit of homework on the individual investment options. So, they may be mutual funds, they may be separately managed accounts just for your plan, in which case you'll need to do a little more homework.

And then you also want to check on whether you're getting any matching contributions. Obviously, that's a huge plus and a huge incentive to invest. Even if the fund is costly or your investment options are lousy, if you are earning the matching contribution, you want to contribute at least enough to get the full employer match.

And finally, look at whether you've got a Roth option within the plan. So, that means that you're taxed on the dollars that you put into it, but it has the nice benefit of offering you tax-free withdrawals in retirement.

Stipp: So, let's say the plan is a looking pretty good on all those fronts. You'd mentioned that you at least want to have enough to hit the employer matching contribution. When you reach that point, how should you decide about how much you should put into the traditional 401(k) and how much you should put into the Roth?

Benz: So, if it's looking really good on all those fronts, I think that you have strong reason to consider just using that as your key retirement funding vehicle before moving over to a Roth IRA. If it's not looking as good, maybe it is costly, the investment options are subpar, you might want to think about splitting the difference a little bit. So, start by investing at least enough to earn the match, then open in an IRA, and maybe it's a Roth IRA, maybe it's a deductible IRA if your income falls below the level that you need to, to contribute to that deductible IRA. But the nice thing about then moving over to an IRA is that you open yourself up to a lot more choices and also you don't have that extra layer of administrative costs.

So, you're getting a little bit of diversification, and if you're looking at a Roth, you're also looking at tax diversification. So, if you're investing pre-tax dollars in your 401(k) plan, think about doing the Roth for your IRA, because you'll have a variety of tax treatment of your retirement dollars when you need to pull the money out in retirement.

Stipp: Do you have any thoughts about how much you should have in the 401(k) traditional versus in the Roth, whether the Roth is available in the 401(k), or whether you're doing it separately in another account?

Benz: It's so individualistic. I think for the average person, say, a high income earner who has been saving assiduously in the traditional 401(k), it's really time to be thinking hard about getting that tax diversification. So, for that person, maybe it is all of the new contributions are going into the Roth 401(k). Also for younger savers, people who are at a fairly low income level versus where they think they'll be in the future, for those folks they probably also want to think about doing the Roth, because they may be in a higher tax bracket in retirement than they are now.

The people who might want to pull back on the Roth option and not do much in the Roth, if anything, would be those who maybe are getting close to retirement and see that they really have not saved much. they may be in tough financial shape when they retire. In that case they might as well continue to do traditional contributions because they're not so concerned about being in a higher tax bracket in retirement.

Stipp: So lastly, Christine, if you look at your 401(k) plan, and it seems like it's not hitting on any of the things that you think it should hit on in those four points that you mentioned earlier, should you just forgo it entirely or is there any reason to have any money in there at all?

Benz: It's hard to say. I've never seen a 401(k) plan that is so terrible that someone should forgo it altogether, mainly because you get that enforced savings aspect within the 401(k), which can be so valuable. But say you do have a truly lousy plan, 2% expense ratios on plain-vanilla stock funds, you maybe want to think about starting with an IRA and then taking full advantage of all the tax-efficient vehicles that are available to you.

So, looking at core ETFs and index funds, municipal bonds for the bond sleeve, but for most people you do get that nice tax benefit with a 401(k). It's hard to say completely forgo that.

Stipp: At the very least if you're going to go outside the 401(k), at least set up automatic investment so that money is going to come out of your account every month and instill that discipline.

Benz: That's a fantastic idea, Jason, to just kind of mimic what's going on in the 401(k) plan.

Stipp: All right, Christine. Thanks so much for joining me and for the tips today.

Benz: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.