The following is a post by MPFJ staff writer, Kevin Mercadante, who is a freelance professional personal finance blogger for hire, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
People sometimes believe that if they have a 401(k) plan that their retirement is covered. That’s sometimes true – if you can make the maximum contribution, and you have an excellent plan with a wide variety of low-cost investment options. But if you don’t, then your 401(k) shouldn’t be your only retirement plan.
Here are some major reasons why you should accumulate retirement savings outside of your 401(k).
Increasing Your Retirement Contributions
If your company caps your retirement contributions at a certain percentage of your income, you may not get the full benefit of the maximum contribution. For example, for 2016 the IRS allows a 401(k) contribution as high as $18,000 (or $24,000 if you are 50 or older). But if you earn $60,000, and your employer caps your contribution at 15%, you’ll only be able contribute $9,000.
At the opposite end of the pay scale, if you earn well over $100,000, the $18,000 maximum contribution may not be adequate for you to reach your retirement goals.
In each situation, you may need to add additional retirement plans in order to reach your retirement investment goals.
Increasing Your Investment Options
One of the common complaints about 401(k) plans is limited investment options. In many company plans, your investment choices are limited to a small number of mutual funds or exchange traded funds (ETFs). In some plans, you are limited to the funds from a single fund family.
This can limit your investment options. For example, if your plan does not offer sector funds, you won’t have the option to invest specifically in technology stocks, energy stocks, or resource related stocks. There may also be no option available for you to invest in real estate through real estate investment trusts (REITs).
Self-directed plans, such as IRAs, allowing you to hold your plan with any investment broker you choose. As such, you can choose a broker that offers the widest variety of investments in such a way that your investment options will be virtually unlimited.
This can also improve return on investment, which can make a huge difference in the size of your retirement portfolio by the time you retire.
Adding Income Tax Diversification to Your Retirement Plan
401(k) plans are great when it comes to income taxes while you are funding your plan. Your contributions to the plan are tax-deductible, and the investment income earned on your capital are tax-deferred. From a tax standpoint, contributing to a 401(k) plan is a double win.
But the dynamic shifts when you retire and begin taking withdrawals. After all, 401(k) plans are not tax-free, but tax-deferred. “Deferred” means that the taxes are simply due at a later date, and that date is when you retire and begin taking withdrawals.
You can get around this problem by simply not taking distributions from the plan – under the assumption that you won’t need the income. But even if you do this, eventually you will be required to take distributions. That requirement will apply once you turn 70 1/2. 401(k) plans are subject to required minimum distributions, or RMDs. That means that distributions from the plan become mandatory at that age.
For this reason, you may want to have certain retirement related investment accounts that will not be tax-deferred when you retire, but not subject to tax at all.
A Roth IRA is one such account. The contributions to this plan are not tax-deductible, but the investment income you earn is tax deferred. But both your contributions and the accumulated investment income can be withdrawn tax-free when you turn age 59 1/2 and have been in the plan for at least five years.
Another alternative here is to have money invested in regular taxable investment accounts. Since you pay tax on the investment earnings in such accounts on an annual basis, you can withdraw money from them that is not subject to income tax.
Either account could be an excellent counterbalance to a fully taxable 401(k) plan.
You Will Need Emergency Funds Outside Your 401(k)
Even if you have a very large 401(k) plan, you will want to have savings for retirement that are held outside of the plan. This is because the primary purpose of a 401(k) is to provide you with income. As such, you won’t want to be withdrawing large amounts of money to cover emergency expenses. That will be a strategy for draining your 401(k) plan prematurely.
For that reason, you should plan to accumulate a significant amount of money to have available to cover expenses that can’t be paid out of regular income. Examples include large uncovered medical expenses, major repairs to your house, the replacement of one or more vehicles, or even money to help your adult children.
Other Retirement Plans to Add to the Mix
There are plenty of choices even if you have a 401(k) plan.
Traditional IRA. You can save up to $5,500 per year ($6,500 if you’re 50 or older) and put the money into a self-directed investment account, maximizing your investment options. Your contributions to the plan will be tax-deductible, however there are income limits which if exceeded will limit or eliminate their tax-deductibility.
Roth IRA. These have the same contribution limits as traditional IRAs, and you can also invest money into a self-directed investment account. However your contributions are not tax-deductible, and there are income limits after which you will no longer be able to make a contribution. But up to that income level you can make contributions even if you are already covered by a 401(k) plan. And as already mentioned, the distributions you take from a Roth IRA are tax-free as long as you are at least 59 1/2 and have had the plan for at least five years.
Regular Taxable Investments. These can include any investments are held outside of a retirement plan. This includes an investment brokerage account with stocks and funds, money held in mutual funds or ETFs, certificates of deposit, or US Treasury securities. There is no tax benefit while you are accumulating this money, but for the same reason you can access it without tax consequences. This is an important part of retirement tax diversification.
Investment Real Estate. Investment real estate accumulates value in two ways – from property value appreciation and from amortization of any financing on the property. And if you can purchase an investment property now, and pay off the mortgage by the time you retire, you’ll have the benefit of either the cash flow from the property from rents, or the proceeds from selling it.
Each of these investments represents a retirement diversification, so that your 401(k) plan won’t be your only retirement plan.
How about you all? How else have you diversified your retirement portfolio?
Share your experiences by commenting below!
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