How much are you saving in your traditional 401(k)? Something like 7% of your paycheck? 10%? More?
If this is you, it’s time to brace yourself for what we’re going to say next:
This is too much!
What could we possibly mean by this? After all, if you listen to the Simply Money radio show, you're always hearing us emphasize saving 20% of your take-home pay. So how could saving something like 7% or 10% in your 401(k) be "too much?"
Because once you hit your 401(k) company match threshold (6%, in many cases), there are other types of accounts that can be better suited for the rest of your money. Just like your investments themselves should be diversified, we want you to diversify the tax structure of the accounts you're saving in.
Here’s what we mean:
Accounts like a traditional 401(k) are “tax deferred,” meaning you get a tax break on contributions now, but you’ll have to pay taxes on withdrawals in retirement.
Conversely, a Roth 401(k) or Roth IRA don’t give you an up-front tax break on contributions, but once you turn 59 ½ and have held the account for at least five years, earnings come out tax-free.
If you use a Health Savings Account (HSA), you get a tax break on contributions, earnings grow tax-free, and if you use the money for qualified medical expenses, withdrawals are tax-free.
And lastly, consider taxable investment accounts. Any earnings in these accounts are subject to capital gains tax when you sell positions inside the account. If you’ve held the positions for less than a year, you’re subject to the short-term capital gains tax which is your ordinary income tax rate. The good news is that if you’ve held the positions for longer than a year, you’ll pay the long-term capital gains rate which is lower than the income tax rate.
Ultimately, how you save really depends on what kind of traditional 401(k) you have:
If you get a company match with your traditional 401(k):
- Save enough in your 401(k) to get your company match
- Next, contribute to a Health Savings Account (if eligible)
- If you have more to save, divert money into a Roth IRA (if eligible) or a Roth 401(k)
- Then, save in a “taxable” investment account
If you don’t get a company match with your traditional 401(k):
- First, contribute to a Health Savings Account (if eligible)
- Next, divert money to a Roth IRA (if eligible) or a Roth 401(k)
- Contribute to your 401(k) or a traditional deductible IRA (if eligible)
- If you have more to save, put money in a “taxable” investment account
The Simply Money Point
You’ve probably been told for most of your life to keep shoving money into your 401(k) (“Save, save save!”). And while the intention is correct, the execution is all wrong. Yes, you should be saving – but you should be saving strategically.
So, while everyone’s situation is different, it generally makes more sense to spread out your money across different kinds of accounts. This way, your money has more flexibility both now and in retirement – some you pay taxes on now, some you pay taxes on later, and some has a lower tax rate in general.
To learn more about planning for retirement, check out our “Retirement Resources” library! You’ll find free online video tutorials, downloadable guides, and live events – like our upcoming Social Security workshops the week of August 6th.