December 09, 2018
Every week, Simply Money’s Nathan Bachrach, Ed Finke and Amy Wagner are answering your financial questions in The Cincinnati Enquirer. If you, a friend, or someone in your family has a money issue or problem, please feel free to send those questions to firstname.lastname@example.org
Tracey from Fairfield: I have access to a 401(k), Roth 401(k), and HSA through work. Is there one I should be saving in over the others?
Answer: Ideally, we recommend saving in all three of these accounts because they all have something different to offer. Plus, we like the idea of spreading out your tax liabilities.
Your 401(k) gives you the opportunity to save money on a pre-tax basis. Pre-tax means your contributions are giving you a tax break now. You’ll then pay taxes on the money once you make withdrawals in retirement. Balances grow tax-deferred.
Your Roth 401(k) offers tax-free growth if certain conditions are met. While you don’t get an up-front tax break because you make contributions with “after-tax” money, withdrawals will be tax-free once you’re at least age 59 ½ and have held the account for at least five years.
Your HSA (Health Savings Account) provides a way to save in a tax-advantaged manner specifically for future medical costs. Contributions are usually made with pre-tax money, the account grows tax deferred, and withdrawals on qualified medical expenses are also tax free. If you take the money out for non-qualified medical expenses after you turn 65, the withdrawal will be taxed just like a 401(k): you’ll only pay ordinary income tax (no additional 10 percent tax penalty). But remember, an HSA is only available if you have a qualified high-deductible health care plan.
Generally speaking, if your employer offers a 401(k) match, save at least enough to get the maximum match provided. Then, save in your HSA. Follow that up with saving in your Roth 401(k).
If your employer does not provide a 401(k) match, contribute to your HSA first. Then save in your Roth 401(k). If you have the ability to save more, then save in the 401(k).
The Simply Money Point is that, just as you should diversify your investments, we believe you should also diversify your tax burden. However, the best way to know how you should be saving given your specific situation is to get a financial plan from a trusted financial advisor (we recommend a CERTIFIED FINANCIAL PLANNER™ or Chartered Financial Consultant®).
Craig in Burlington: I have an IRA and just realized I put too much money in for this year. What can I do?
Answer: In 2018, you’re allowed to contribute up to $5,500 to a traditional IRA or Roth IRA (if you contribute to both, the combined limit is also $5,500). If you’re older than 50, you can make an additional $1,000 contribution per year (known as a ‘catch up’ contribution). The IRS considers anything over the annual limit as ‘excess,’ and you have to pay a six percent penalty every year that extra money sits in your IRA.
It’s good you noticed this mistake now. Since you caught it before the 2018 tax filing deadline of April 15, 2019 (or October 15, 2019, assuming you normally file an extension), the IRS allows you to remove excess IRA contributions (and their earnings) fairly painlessly. Just contact the company in charge of your IRA and ask what kind of paperwork you need to fill out. You’ll avoid the six percent penalty, but you’ll have to pay ordinary income tax on any of the excess contributions’ earnings. And, if you’re younger than 59 ½, you’ll get dinged with a one-time 10 percent early withdrawal penalty on those earnings as well.
However, let’s say you didn’t realize your mistake until next year, after you filed your 2018 taxes. Now it gets a little more complicated, so we recommend consulting with a trusted tax professional.
Here’s The Simply Money Point: It’s important to correct this mistake as soon as possible. Moving forward, make it a point to note annual contribution limits and your adjusted gross income (this determines your eligibility to save in a Roth IRA). And record each time you make a contribution during the year, including the amount. This running tally will help you avoid overcontributing.
Responses are for informational purposes only and individuals should consider whether any general recommendation in these responses are suitable for their particular circumstances based on investment objectives, financial situation and needs. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing, including a tax advisor and/or attorney. Nathan Bachrach and Ed Finke and their team offer financial planning services through Simply Money Advisors, a SEC Registered Investment Advisor. Call (513) 469-7500 or email email@example.com.