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How to Prioritize Tax-Advantaged Accounts

Morningstar's Christine Benz offers tips on deciding where to put money first among 401(k), IRA, and Roth accounts.

Jason Stipp: I'm Jason Stipp with Morningstar. It's tax relief week on, and today we're talking about your tax-advantaged accounts. These are your 401(k)s, your IRAs, your Roth IRAs. There are a lot of options there. So here with me to talk through some of these is Morningstar's Christine Benz. She's director of personal finance. Thanks for joining me, Christine.

Christine Benz: Jason, nice to be here.

Stipp: So, when I'm thinking about these tax-advantaged accounts that are treated differently and that have some different pros and some different benefits, where should I start with where I should put my money away for these retirement accounts?

Benz: The first starting point is to check on whether you're earning any sort of matching contributions on your company retirement plan contributions. So, that's the starting point. If you are, you should definitely invest at least enough to earn that match, regardless of whether the company retirement plan is good or not so good.

Stipp: Sure. So these are your 401(k), the 403(b). These are the ones where they take money out of your paycheck before taxes and put it in so that you kind of get a little bit of a tax benefit now for those, and then when you take the money out later, you're actually taxed on that.

Benz: Exactly. And those company retirement plans are so easy to invest in, because you have that enforced discipline. And also, as you said, the money is coming out on a pre-tax basis, so it's not really all that painful.


Stipp: Right. So we're going to talk a little bit in a separate video about how to determine whether your 401(k) is good quality. But certainly, you want to at least try to get that match if you can. But let's say that, we know, we sort of examine our 401(k), the options maybe don't look that great, it seems a little expensive. What would be my next step, then, if I still had money I wanted to invest?

Benz: For most investors, the Roth IRA is going to be a good next step. And there are a couple of key reasons. First of all, the tax treatment can be particularly attractive if you think you may be in a higher tax bracket when you retire. And maybe we'll all be in a higher tax bracket when we retire. So the opportunity to get tax-free withdrawals is very attractive. And also you don't have to take withdrawals in retirement if you don't need that money, so you can pass it on to your heirs if you want to. And the other key advantage to any sort of IRA is that open architecture, which you do not get with most 401(k) plans where you are confined to a preset menu of choices.

Stipp: So, certainly a lot more options and a lot more flexibility by going to that IRA. The taxes are different with a Roth IRA in the way they're handled, so you know, I think that that could be beneficial. So, even if my 401(k) plan seems like it's pretty good, should I still think about putting money in a Roth IRA?

Benz: Yes. And you hit on something really important, Jason, and that's tax diversification. So we all know about asset class diversification, having money parked among stocks and bonds and international and so forth. You also want the same thing with your tax treatment of your retirement assets. So maybe you're a person who has amassed a lot of assets in your 401(k). So you've got a lot of money that's going to be taxed upon withdrawal. It's an attractive idea to get at least some of your assets into that tax-free withdrawal column, which is what you get with a Roth IRA.

Stipp: So when you get down the line, you have a little more options and more flexibility depending on what the situation looks like.

Benz: Exactly.

Stipp: So one more option that's available to some investors, and maybe it will be available to more as we go along, is the Roth 401(k). So, here's something else in the mix. How should I think about that if it's available to me?

Benz: It's increasingly available on plans, and I think there are two categories of individuals for whom the Roth 401(k) contributions make a lot of sense. The first would be the person just starting out, maybe, in a low tax bracket relative to where they think they'll be when they retire. So that would be one candidate. And the other would be the person, the same person who might already have amassed a lot of assets in a traditional 401(k) who is looking for some retirement assets that will not be taxed upon withdrawal and retirement. So for that individual, where maybe they're maxing out the 401(k) contributions and perhaps have not been able to contribute to a Roth IRA to date due to income limitations, that person might want to look at a Roth 401(k) as well.

Stipp: It gives them the option to have a little bit of that diversification if they want it on the tax side, then.

Benz: Exactly.

Stipp: OK. Well, thanks for your insights, Christine.

Benz: Thanks, Jason.

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