Ask Money

Where to put extra savings

Chris Farrell May 24, 2010

Question: I recently received a raise at work and would like to pursue additional retirement options for this new extra money. I currently have a Roth IRA, a traditional IRA (because my income exceeded the maximum for a Roth IRA), and contribute to my employer’s 401k program. Do you have any suggestions for additional retirement savings? Should I open another traditional IRA? Continue putting the money in savings? Richard, Baltimore, MD

Answer: First of all, putting some of the extra money that comes from a raise into savings is an incredibly smart financial strategy. It’s a discipline that pays off big with time. Bravo.

Now, there’s nothing wrong and there’s a lot right with increasing your contributions to tax sheltered retirement savings plans. For instance, if you aren’t putting the maximum into your employer’s 401(k) plan I would put the raise into that retirement plan. I don’t see any reason for opening up another traditional IRA, assuming you are satisfied with the choices in your current IRA. If that’s the case, it would be cheaper and simpler to send more savings into that retirement program.

Still, it seems to me from your question that you’re doing well saving for retirement. What would you think of taking the savings and putting it into taxable investments, from a simple savings account to a broad based equity index fund? In other words, a well diversified portfolio.

Yes, you’ll pay taxes on dividends, realized capital gains, and interest payments along the way. But the big advantage of taxable accounts is financial flexibility. Specifically, if you pull money out of a 401(k) you’ll pay a 10% penalty plus your ordinary income tax rate on the withdrawal. You could borrow from the plan, but that maneuver reduces the long-term return on retirement savings. The Roth offers a good safety net since contributions can be withdrawn tax-free and penalty-free (the same isn’t true for any earnings, though). But with the Roth the real investment kick comes with the compounding effect of time. It’s better to leave it alone except in a severe financial pinch.

With a taxable account you can tap the money at any time without penalty. You will pay Uncle Sam a long-term capital gains tax rate when you cash it in–assuming you’ve owned the investment for more than a year–but it’s still at a lower rate than ordinary income tax rates. Another benefit to investing in taxable accounts is tax diversification. For instance, in retirement it may sometimes be tax smart of leave tax-sheltered savings alone and tap into taxable accounts, and vice versa.

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