IRA and 401(k)

You've set up an emergency fund. You've created a budget that works for you and are sticking with it. You have an index fund with money deposited automatically into it each month.

Now what? Is there anything else you need to know?

I sat down with Yitzchak Goldsmith, a local certified financial planner, to find out.

WHY INVEST? 

"The average person's goal when investing money is to accumulate the most money possible by earning the highest rate of return, based on their risk tolerance and time frame," Yitzchak says. "People are living longer and have larger families than ever before, and expenses are rising. They want to have enough to cover all expenses, retire respectfully, leave over an inheritance, and enjoy some of it along the way. So it's not enough to just have a large amount of money; you need to be strategic about where you put it and how you plan on accessing the money. You need to think about the end goal and how decisions you make today will impact that.”

“Just because you have a higher account balance, doesn't necessarily mean it will produce a higher after-tax income stream. It's almost the equivalent of focusing on gross profit instead of net profit. Instead, the goal is to produce the most income by creating a more efficient plan. By doing this, you can potentially have more income come out of a smaller portfolio rather than having a larger portfolio producing less income. This allows you to enjoy more of your money now instead of having to put it away for later.”

"People ask, 'Why do I need an adviser? Why can't I just do it myself?' If all you care about is how much money you accumulate, you can do it yourself. But if you want to be tax efficient and make strategic moves to be able to enjoy your money while still being able to accomplish your retirement goals, that's where a financial planner comes in. That's besides the hand-holding when there is market volatility."

Where to Invest

There are several types of accounts you can set up that can help maximize your income from a tax perspective. Here's a summary based on Yitzchak's advice and my own research:

IRAs (INDIVIDUAL RETIREMENT ACCOUNTS)

The money can be invested just like in a regular investment account-in stocks, bonds, mutual funds, ETFs, etc. There is a maximum that you can put in per year-currently $7,000 per person ($8,000 if you're over 50). This number increases based on inflation.

You cannot take money out before a certain age - currently 59.5 years old - without incurring a 10% penalty. There are exceptions that allow you to take out certain amounts before that age, such as for higher education, first-time home buying, and when you have a baby. In a Roth IRA, you can take out the principal (the amount you put in) without a penalty or tax.

You have until you file taxes or April 15 of the following year (whichever is earlier) to contribute to an IRA. There are two types of IRA for individuals (not businesses):

Traditional:

Money you put in is tax deductible - you don't count it as income, so you don't pay any taxes now. It grows tax deferred, meaning you don't pay taxes on the growth. But you will report and pay taxes as earned income when you take the money out.

Roth:

You report the income, pay the taxes, and then put the money in. This money is never taxed again, even when you take it out. There is no deduction except in limited situations for low-income people. To be eligible for a Roth IRA, you need to make below a certain income, unlike a traditional IRA, which has no income limit.

So which one should you choose?

It depends.

If you're in a high tax bracket now and think you'll be in a lower tax bracket when you retire, traditional makes sense; you get a higher deduction now and pay the taxes at a lower rate on the way out. On the other hand, if you are in a low tax bracket now, it may make sense to do the Roth and pay the taxes now and later withdraw tax free.

If you're in the middle tax bracket, it's not as clear cut which is better, and you should speak with an accountant or financial adviser.

You can have both types. You can meet with your adviser and decide based on that year's income which type makes sense to put into for that year. You can also convert from a Traditional to a Roth at any time.

If you really want a Roth and your income is too high, you can put the money into a Traditional and then immediately convert to a Roth. This is called a "backdoor Roth." There are tax rules you need to follow when employing this strategy.

401(k)

401(k)s are retirement accounts that are offered by employers. They can also be Traditional or Roth. The contribution limit for a 401(k) is currently $23,000. These accounts also allow you to take a loan against the value. On the other hand, usually you're limited to the investment options that the 401(k) sponsor offers you, and there may also be higher fees than if you invested yourself or even with an adviser.

A big benefit of a 401(k) is that in many companies, the boss will match a certain amount based on what you put in.

You can have both a 401(k) and an IRA and contribute to both in the same year. After you leave a company, you can roll your 401(k) into an IRA tax and penalty free, or leave it where it is.

THE BEST OF BOTH WORLDS

Another thing to keep in mind: the money contributed into pretax accounts doesn't count as taxable income.

So if your income is just above the limit for eligibility for Medicaid, or other government programs, or if your earned income is above the limit for the Earned Income Credit, you can potentially  lower it by contributing to these accounts. Although you won't be able to use the money until much later, you can have your cake and eat it too - you don't have to reduce your actual income while still getting the benefits of a lower taxable income.

Knowing the Numbers

Back to Mr. Goldsmith: "I do want to mention that usually I advise people to focus on the biggest hurdle first, which for Orthodox Jews would be a down payment and then weddings. But you should not totally ignore future needs. Especially when it comes to retirement accounts, compound investing really adds up. So if over 50 years you're putting away even a small amount of money each year, you can potentially end up with a nice amount at the end. The earlier you start, the better off you are.”

"I often talk to families to discuss how much is needed for certain goals (like weddings and retirement), and we'll come out with a monthly amount to put away. Many times, they will say that they can't afford that, so we'll target a smaller goal. People sometimes wonder, ‘What's $25-$50 a month going to do for me?’ But when they see that it does make a difference, it motivates them to cut down on some of those discretionary expenses and put money away. Just knowing the numbers really needed will often motivate them to put more money away and try to reach the original goal."

“If you think you can't put anything away, here are a few tricks:

Pay Yourself First: Put money away at the beginning of the month and then figure out how to make the rest of the month work. If you wait until the end of the month, there is usually nothing left to invest.

Start with an amount you won't feel in your budget and then keep increasing.

If you get a bonus or gift, put that away before you spend all of it (but keep some to enjoy).

If your income goes up, maintain your current life- style and invest the rest. Those little numbers add up. Something is better than nothing.”