Taxes can be one of the main drags on the growth of your portfolio. That’s why tax-advantaged accounts such as 401(k) and IRA accounts can be such a boon when you’re saving for retirement. But how much should you put into these accounts as opposed to regular taxable accounts? The answer is “as much as you can” in order to minimize your tax bill, though there are a couple key constraints on how much you “can” allocate to these accounts.
This first constraint is that there are usually large penalties if you withdraw money from tax-advantaged retirement accounts when you’re under the age of 59 ½. Therefore any money you think you’ll need to pay for expenses before that age shouldn’t be put in a tax-advantaged account. You should also make sure you have money set aside outside of retirement accounts to act as a buffer against unexpected expenses. Once you’re established this buffer, you should put as much money into tax-advantaged accounts as you can afford to.
The second constraint is legal: the government puts a cap on how much you can put into retirement accounts each year. The annual limit on how much you can contribute depends on the type of retirement account. In 2014 the contribution limit for 401(k) accounts is $17,500, for example, while the limit for IRA accounts is $5,500. These contribution limits are higher for people over the age of 50.
Putting as much money into tax-advantaged retirement accounts as you can, while avoiding the penalties you’d have to pay if you withdraw money early or exceed the annual contribution limits, can make it substantially easier to meet your retirement goal.