Should I Contribute to an IRA?

With tax season in full swing, my inbox has been flooded with emails from clients asking if they should contribute to an IRA. If I have clients asking me this question, I’m thinking some of you might have the same question so I want to help.

Questions to Consider

When I get this type of question from a client, I quickly respond to it with a few more questions:

1. What are your current financial goals?
2. Do you have access to and are you contributing to your 401(k)? If yes, how much?
3. Do you have access to a Roth 401(k) within your employer plan?
4. What is your current income?

Not the shortest list but each response gives me the details I need to help my clients answer this question and keep them moving forward towards their financial goals.

Financial Goals

It’s so important to first identify financial goals. If you haven’t taken the time to think through short-term, mid-term and long-term goals, take this opportunity to do so. If you need some inspiration, I encourage you to take a look at this post.

If your list of financial goals includes paying off credit card debt, or a major purchase in the next 6 -18 months, I would prioritize saving for those near term goals over retirement IRA savings. Those dollars would be better served paying down interest bearing debt or speeding up the time horizon of a near-term goal.

If there aren’t any near-term goals or if you already have the savings for those near-term goals under control, then I would say that an IRA contribution might be in your future and keep reading.

Retirement Savings Hierarchy

If you made it past the first question, it has been established that the extra savings are for retirement. Question number two and three are to understand if you have access to an employer retirement plan {401(k) or 403(b)}, how much you are currently saving and which provisions are available in the plan. Based on your personal answers to questions two and three, here are my thoughts.

• Not eligible for a 401(k) or 403(b) –> Contributing to an IRA might make sense. Other qualified accounts might be better suited like an i401(k), SIMPLE IRA or SEP-IRA. Talk with a tax professional before moving forward.
• Maxing out 401(k) contributions ($19,500 in 2020) –> Contributing into an IRA is the next retirement bucket to fill.
• Contributing but not maxing out 401(k) with a Roth provision –> Consider increasing 401(k) contributions first before contributing to an IRA.
• Contributing but not maxing out 401(k) without a Roth provision –> Contributing to a Roth IRA might make sense. Need to first understand Roth eligibility.

What this demonstrates is the retirement savings hierarchy which emphasizes the most tax efficient ways to save for a retirement.

1. Employer Retirement Plan – 401(k) or 403(b)
2. Backdoor Roth IRA
3. Health Savings Account
4. Taxable Account

In simple terms, if savings are earmarked for retirement, focus on filling up each bucket in the order listed above. If you can’t fill the first retirement bucket, hold off on filling the next bucket for the time being.

The one exception, as I see it, is if your employer does not have a Roth 401(k) provision. In that case, it may make sense to open and fund a Roth IRA based on your income levels. If you find yourself in this situation, I recommend speaking to a tax professional or financial advisor to review your unique situation.

I wish I understood the concept of a savings hierarchy when I was just starting out in my career. Admittedly, I funded a Traditional IRA in my early working years and wasn’t maxing out my 401(k). The result is a slightly tricky circumstance which is preventing me from making Backdoor Roth Contributions. I have a few options on how to navigate this financial predicament that I plan to share in upcoming posts. Stay tuned!

Income Considerations

We made it to question four! If you’ve made it this far, you should know if you are ready to start filling the next retirement account bucket, an IRA. At this juncture there are two IRA options:

• Traditional IRA
• Roth IRA

To understand the difference between these two accounts, I recommend reading this recent post that outlines the major differences between Roth and Traditional before moving ahead.

Ultimately, your current income is going to have the final say on which type of IRA is funded. In 2020, the income amount to look at is $124,000 for a single tax filer or $196,000 if you file taxes married jointly.

Using a single filer as an example, if income is less than $124,000 the move is to make a direct contribution into a Roth IRA. If that same single tax filer makes more than $124,000 the move is to make a non-deductible contribution into a Traditional IRA and proceed with the Backdoor Roth contribution strategy.

Investing

We made it through all four questions so you would think that was the end of this post but its not. Once a contribution is made into an IRA don’t forget to invest those funds in a prudent investment strategy. Remember, those dollars are earmarked for retirement and cannot be accessed without penalty until your age 59.5. For some that is multiple decades away. In the case of funds with an investment time horizon of over 7 years, it makes sense to have an investment strategy with a focus on growth rather than income.

Well that does it. Hopefully this post gave you a few questions to consider that will help you walk through your options based on how you answer those four questions. As always, if you have questions that weren’t covered or want to talk about your unique situation, feel free to reach out!