3 Under-Rated Retirement Accounts

September 03, 2015

One of the most common questions we get is how to prioritize funding different types of retirement accounts.In an ideal world, we would max them all out but most of us need to figure out which ones should take priority. I recently read this article that attempts to answer that question. While I generally agree with the points, there are three things that this article and many similar articles I’ve read tend to underestimate:

1)Roth IRA

The article suggests funding a Roth IRA only after you’ve maxed the match in your employer’s retirement plan. I get it. It’s hard to turn down free money.

But one thing that could be even more valuable for many people is having savings that they can access. Otherwise, you could run up high-interest debt or even face repossession of your car or foreclosure or eviction from your home in an emergency. While you may be able to take a loan or hardship withdrawal from your employer’s retirement plan, loans are limited to half of your vested balance (up to $50k) and hardship withdrawals are limited in terms of what expenses you can take withdrawals for and are subject to taxes and possibly a 10% early withdrawal penalty if you’re under age 59 1/2.

That’s where a Roth IRA comes in. Unlike other retirement accounts, you can withdraw the sum of your contributions at any time and for any reason without tax or penalty. If you withdraw earnings before 5 years and age 59 ½, they could be subject to taxes plus an early withdrawal penalty but after that, they are tax-free. This means the contributions are available in an emergency but whatever you don’t use can grow to eventually be tax-free for retirement (which can also discourage you from raiding the account frivolously).

For this reason, you might want to fund a Roth IRA even before getting that match. Just be sure to keep the Roth IRA in something safe like a savings account or money market fund until you have enough emergency savings somewhere else. At that time, you can then invest the Roth IRA more aggressively for retirement.

2) HSA

One account that’s often ignored when it comes to retirement (including in the article above) is an HSA. If you have an HSA-eligible health insurance plan, you can contribute pre-tax dollars to an HSA and then use the money tax-free for qualified health care expenses. Anything you don’t use stays in the account and can even be invested for the future. If you use the money for non-qualified expenses, you generally have to pay taxes plus a 20% penalty on it but the penalty goes away once you turn age 65. That’s why it can be considered a retirement account.

If you are eligible for an HSA, consider maxing it after building your emergency fund and getting the match in your empoyer’s plan. After all, it’s the only account that’s both pre-tax AND tax-free (for health care expenses but I’m sure you’ll have those in retirement). In fact, you may even want to pay for health care costs out-of-pocket to let your HSA money continue growing tax-free.

3)Traditional Pre-Tax 401k

Like many financial experts, the article recommends Roth over traditional 401k contributions. However, most people will probably pay a lower tax rate on their 401k withdrawals in retirement than they would pay on the contributions today even if they retire in the same tax bracket. That’s because your contributions are taxed at your highest marginal tax bracket while a lot of your withdrawals will likely be taxed at lower brackets first. You also have the option of converting pre-tax accounts to Roth accounts but you can’t do the reverse.

Keep in mind that there are exceptions to each of my points too. Your income may be too high to contribute to a Roth IRA. You may not be eligible for an HSA. You may have reason to believe that your average tax rate will actually be higher in retirement. In the end, your priorities will depend largely on your personal situation. If you’re not sure what makes sense for you, consider seeking guidance from a qualified and unbiased financial planner.