One of the trickier decisions of saving for retirement is determining which accounts to prioritize with your savings.
Is it most important to max out a 401(k) before an IRA? At what point should you use a taxable account for retirement savings? How does debt play into these decisions?
This is one of those truly personal finance moments because everyone has different circumstances.
Listen now and learn:
- The ideal order for prioritizing your retirement savings
- How to utilize the most underrated retirement account
- A framework for including savings goals beyond retirement
Episode
Outline
One of the trickier decisions of saving for retirement is determining which accounts to prioritize with your savings.
Is it most important to max out a 401(k) before an IRA? At what point should you use a taxable account for retirement savings? How does debt play into these decisions?
This is one of those truly personal finance moments because everyone has different circumstances.
Today I’m going simplify the many options for retirement investing along with multiple variables that go into the decision-making process, by explaining the general order of accounts to use in order to maximize your retirement savings.
I find it useful to think of each of these categories as buckets: you save into that bucket until it’s full and then move on to the next bucket.
The first bucket is…
1. Invest Enough in Your Company Retirement Plan to Earn a Match
I see a lot of 401(k) plans, some good and some bad, but this first bucket is the most important regardless of the quality of your retirement plan because it’s hard to find a guaranteed 100% return on your investment.
An employer match does just that. For example, if your employer has a 3% match and you make $100,000 a year, you’ll need to contribute at least $3,000 of your own money to your 401(k) to be entitled to your employer’s full matching contribution.
So if your employer offers a match on some portion of your 401(k) contributions, invest at least that much. Otherwise, you leave free money on the table.
Once you invest at least enough in your employer plan to receive the match, then move on to the next bucket.
Now, I’ve been saying 401(k), but this applies to any employer-sponsored retirement plan such as 403(b)s, 457s, or Simple IRAs.
If your employer doesn’t offer a match, then I’m actually going to encourage you to move on to the next bucket prior to investing in your employer’s plan.
And that next bucket is…
2. Invest the Maximum Allowable Amount in a Health Savings Account (HSA)
A Health Savings Account (HSA) is a special account available to people participating in a High Deductible Insurance Plan that can be used to pay for medical expenses and other qualifying health-related costs.
I often find that people are more familiar with the FSA or Flexible Spending Account, but that’s different.
The HSA, when used as a retirement savings vehicle, offers a unique triple tax-advantage unmatched by any other type of retirement savings accounts by offering:
- Contributions that are 100 percent tax-deductible
- Interest and earnings are tax-deferred
- Withdrawals used to pay for qualified medical expenses are tax and penalty free
Healthcare costs are a big part of retirement spending, so being able to make tax-free withdrawals for those expenses is pretty advantageous, but it gets better. If you keep your receipts, you can withdraw funds for past medical expenses, too.
For example, let’s say you have an HSA of $1 million at retirement, but that your medical expenses don’t require nearly that large of a balance. You can make tax-free and penalty withdrawals for medical expenses from your working years. Of course, this requires you hold on to medical receipts, but there are apps for doing so and even some HSA providers have that feature built into their platform.
I use Lively, for example, and scan in my bigger medical expenses to my Lively HSA account so that I can make withdrawals in the future if needed.
The max an individual with self-coverage can contribute to a HSA in 2021 is $3,600 and for those with family coverage the limit is $7,200.
If this all sounds too good to be true, I’ll admit that I felt the same way. Usually there is a catch.
I suppose the big catch is that for this strategy to work well, you need to have enough cash flow to contribute the maximum allowable amount each year to your HSA and manage to pay for medical expenses out of pocket. That’s what allows you to leave those HSA contributions invested for years to enjoy unusual tax benefits and compound growth.
Of course, paying for your medical expenses without tapping your HSA savings requires not just sufficient cash flow, but it also helps to have a decent emergency fund to fall back on if you have large unexpected medical expenses.
The other “catch,” if you want to call it that is the extra legwork involved in using a HDHP rather than the more traditional PPO or a Preferred Provider Organization plan.
Because you’re basically paying for the full cost of your medical expenses out of pocket until you hit your deductible rather than making lower copayments with a PPO, using a HDHP also requires you to pay closer attention to the treatment you receive and what you’re billed for.
Many people prefer the convenience of saying yes to whatever tests the doctor wants to run and letting insurance handle the bills. But when you’re paying out of pocket, you have to take ownership of your care and make cost-effective decisions.
In return for that extra effort, though, you’re getting a really powerful tool for retirement. And even if you end up dipping into your HSA savings to cover some medical bills, you’ll still receive tax breaks on your contributions and the benefit of lower monthly premiums.
One last thing before moving on from HSAs…In order to access an HSA, you must be in a High Deductible Health Plan.
Not all employers offer this type of coverage and a HDHPs isn’t a good choice for everyone. You’ll often hear people say HDHPs tend to be great for someone that’s young, healthy, and don’t have children. But I think those categorizations exclude too many people.
In reality, it comes down to your expected medical expenses. If you or your dependents utilize a lot of specialists or require regular hospitalizations, a PPO may be better for you.
Health insurers offer calculators online to come up with expected medical expenses, so if you go through that process, then here is how I would choose between a HDHP and a PPO if you have the choice:
Choose HDHP if:
[Expected Medical Expenses] < [Savings in Premiums + Employer Contributions + PPO Deductible]
Otherwise, choose PPO.
So bucket #2 is a Health Savings Account, bucket #3 is…
3. Invest in Roth IRA or Deductible Traditional IRA
Whether you can invest in a Roth IRA or deductible Traditional IRA depends on your income.
If you’re eligible for a Roth IRA, then this is the next place to direct retirement savings. If you can’t invest in a Roth account, the next best option is to make contributions to a traditional IRA, so long as you are able to deduct the contributions from your income.
Both Roth and Traditional IRAs allow your money to grow tax-free, but the difference is the timing of tax payment.
A Roth IRA is funded with after-tax dollars, meaning your contributions don’t receive a tax deduction on the way in. But your withdrawals from a Roth IRA are tax free.
A Traditional IRA, on the other hand, is funded with pre-tax dollars – meaning you deduct the contribution from your income – and withdrawals are taxed as ordinary income.
If your income is too high to qualify for a Roth IRA or a deductible Traditional IRA, you can still contribute to a nondeductible IRA and enjoy tax-deferred growth, but that bucket comes a little later.
Deeper Reading: Should You Use a Traditional IRA or Roth IRA For Retirement Savings?
4. Invest the Maximum Allowable Amount in Your Company Retirement Plan
Employer-sponsored retirement plans are usually the cheapest place to access a diversified set of investments for retirement.
More and more plans these days allow you to make contributions to a Roth or Traditional account.
If you expect to be in a higher tax bracket during retirement than the one you’re in today, the Roth 401(k) is the superior option. If you expect to be in a lower tax bracket during retirement than you are today, a Traditional 401(k) probably makes more sense.
If you aren’t comfortable projecting whether your taxes will be higher or lower at retirement, consider making contributions to both the Traditional and Roth options. This strategy is known as tax diversification.
I’ve been saying 401(k), but if you work for a nonprofit entity with access to a 403(b), this applies to you as well and you should be aiming to max out that vehicle at this stage.
The same goes for government employees with access to a 457 plan. Smaller employers sometimes provide Simple IRAs or a simplified employee pension (SEP) IRA option, both of which fall into this retirement savings prioritization category, too.
Now, if you have a really good plan, then it might make sense to prioritize this bucket before the IRAs described earlier.
There are two main things I look at in determining if a plan is really good or bad.
1. Low fees are the big one:
Most 401(k) plans have a variety of fees. The expense ratio of the funds is the most commonly recognized one, but there are also fees that go to the investment advisor, the record keeper, and the third-party administrator of the plan.
Fee disclosure is required by law, so when you get your statement, look at the total cost of being a participant in your plan.
I’d say all in costs below 0.50% is really good. All in costs above 1.50% is closer to the really bad categorization, but sometimes smaller companies with less than 50 employees will be in that range.
2. Investment Lineup is the second
It’s easier to talk about the things that make an investment lineup bad.
For example, a mutual fund lineup that only includes actively managed funds is less than ideal. It’s becoming rarer for plans to not offer at least a few low-cost, passively managed funds, but if you’re plan doesn’t offer some that’s definitely a minus in my book.
Traditional active management uses security selection and market timing in an attempt to beat a benchmark such as the S&P 500, MSCI EAFE or Barclays Aggregate Bond Index.
While active management sounds appealing, since the idea is to beat the market, the failure of active management is very well documented.
However, the worst fund lineups, IMO are those that mostly offer annuities. This is more commonly seen in the 403(b) space, particularly in plans that serve teachers. Annuities tend to be more expensive than mutual funds with similar exposures and they have far less flexibility when you change employers or withdraw your money in retirement.
Bucket #5…
5. Invest in Traditional Nondeductible IRA
Contributions to a nondeductible Traditional IRA do not receive a tax break and withdrawals are taxed as ordinary income during your retirement. You will, however, enjoy the benefit of tax-deferred compound growth.
For some investors, contributing to traditional nondeductible IRAs and converting the balances to a Roth IRA at a later date can be a good strategy, particularly if they expect to be in a higher tax bracket in retirement. This strategy is known as a backdoor Roth contribution.
Converting an IRA to a Roth IRA requires you to pay ordinary income taxes on any appreciation and earned income experienced in any of your IRA accounts, not just the account being conerted. That means the a Roth conversion decision requires an analysis of the tax cost, your life expectancy, and the desired beneficiary of the assets.
There are a lot of nuances with this strategy, so I highly recommend you read my article on the tax benefits of a partial Roth conversion.
But in my opinion, the tax benefits of Roth conversions are best for retired investors under the age of 72 with little to no ordinary income. If you’re working and have an existing IRA with considerable appreciation, this strategy is often not worth it
Finally, bucket #6…
6. Invest in a Taxable Account
If you’ve reached this point, you’re doing a great job saving for your retirement.
While you’ve exhausted the best tax-advantaged options, you can always invest in a taxable account. The key here is to be aware of the tax efficiency of your investments.
Assuming you are utilizing the tax-advantaged retirement accounts above, there may also be opportunities to benefit from asset location strategies.
Get Your Questions Answered On The Show
Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.
If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.
Until next time, to long-term investing!
About the Podcast
Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
Support the Show
Thank you for being a listener to The Long Term Investor Podcast. If you’d like to help spread the word and help other listeners find the show, please click here to leave a review.
Free Financial Assessment
Do you want to make smart decisions with your money? Discover your biggest opportunities in just a few questions with my Financial Wellness Assessment.
