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When to Use Tax-Advantaged Accounts

When to Use Tax-Advantaged Accounts

Tax-advantage savings plans, like 401(k) plans and individual retirement accounts (IRAs), help your money grow faster than taxable investments, but they’re not always the right place for all your savings.  There are circumstances when it can be more advantageous to keep your money in a taxable investment vehicle.  Here is a run-down on when one choice or the other might be appropriate.

Put Your Money in a Tax-Advantaged Saving Plan When:

  • Your employer matches your contribution.  It’s rare that taking advantage of free money doesn’t make sense.  It’s like getting an immediate return on your investment.
  • You have savings equal to at least three months of living expenses in safe and readily available savings vehicles and if you have dependents, adequate life insurance coverage.
  • You own a home and are comfortably meeting your monthly mortgage payments.
  • You haven’t met your goal for a retirement nest egg and need the return-enhancing advantage of tax-free compounding to reach it.

Consider Not Contributing to a Tax-Advantage Plan When:

  • Either you’re at the limit of your employer’s matching contribution or your employer doesn’t offer one.  (Though even in these cases, it may still make sense to contribute to your 401(k), as long as the plan’s fees and expenses are low and it offers sufficient diversification.)
  • The investment choices in your employer’s plan charge high annual expense fees.  The pretax advantage of contributing to a 401(k) plan can be eroded by fees of 1.5% a year.
  • You’re in a high tax bracket and want to invest in individual equities for long-term capital gains.  Rates on long-term gains are well below the highest federal income tax bracket; and unless you contribute to a Roth IRA or Roth 401(k) plan, you’ll have to pay ordinary income taxes on stocks’ gains in a traditional IRA or 401(k) plan.
  • You want to diversify beyond the choices available in an employer’s retirement plan.  If this is the case, you may still want to contribute to an IRA, but through an account with sufficient diversification options.
  • You want municipal bonds to be part of your portfolio.  If you hold municipal bonds in a traditional IRA or 401(k) plan, any interest income, even tax-exempt income, will be taxed at ordinary income tax rates when withdrawn.  It is better to hold municipal bonds in taxable accounts so tax-exempt interest income is not taxable.

As financial planning decisions always do, the decision to invest in a tax-advantage or taxable retirement plan depends on your current situation and your goals for the future.  Please call if you would like to discuss this I more detail.

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