Where should you put your next dollar of long-term savings?
Should it go to after-tax or pre-tax retirement accounts?
When should you start using taxable accounts?
These questions are fundamental to efficiently building wealth and reaching financial independence. Yet every financial guru seems to have a slightly different answer these days. Is it really that controversial whether you use a Roth or a Traditional 401k? Is there a one-size-fits-all answer?
The answer to every personal finance question is personal—it depends on your specific situation and personality. This makes financial planning both interesting and more complicated than it often needs to be, and is one reason that I have been studying personal finance for my entire adult life.
There’s a simple set of rules for where you should put your long-term savings first that fits a large majority of Pathway to FI readers, who are interested in reaching financial independence quickly and living their best lives along the way.
Use your retirement savings accounts in this order, and maximize their advantages before moving on to the next:
Keep reading to understand why I came to these conclusions and how to maximize their benefits.
1 Get the Employer Match First
Do not miss out on an employer match. It’s free money! An immediate 50-100% return!
I have only run into one case where someone disagrees with this general advice, and I happen to respect what he has done to improve the financial lives of millions of people. Dave Ramsay’s advice has reached so many people in part because it’s simple and unwavering. He doesn’t tell people to do 5 things at once when they are in credit card debt—“save for retirement, your child’s college, a down payment on a house, and a new car while you’re at it”—but to focus on debt and debt alone until it’s gone from your life forever.
I still recommend his bestselling book, Total Money Makeover, for those who are at the Trailhead of their financial journey and need to getting rid of credit card debt. His approach will get the job done as quickly as possible. It focuses on a person’s psychology, which is more difficult to overcome than logic. People don’t get into debt through logic.
But I also agree with the math presented in this article, showing that the guaranteed return of an employer match beats even an oppressive 18% credit card interest rate.
If your debt is gone in 12 months or less, you won’t miss out on too much employer matching with Dave Ramsay’s approach. If it will take longer than that, you need to get serious about your debt so that it doesn’t follow you for the rest of your life. That’s why Ramsay recommends having just $1,000 in an emergency fund, picking up a side job, and using every extra penny to accelerate the process.
Make it painful. Make it go away.
Debt aside, the first place where you need to put your savings is where your employer will match it.
2 Health Savings Account (HSA) – the best retirement account ever invented
I laid out the advantages of using an HSA as a retirement account in 5 Financial Mistakes that I Have Made in Life. This means paying medical expenses out of pocket rather than raiding your HSA for co-pays and deductibles during your working years. But don’t forget to save the receipt to be reimbursed in the future since there is no limitation on how old the expense can be!
HSAs have more tax advantages than any other account—period. You will never have to pay taxes on the savings or the growth if your HSA dollars are (eventually) used for qualified medical expenses. They can also be used in the same way as any other retirement account after you turn 65 if you absolutely need it, but you will then have to pay income tax just like those accounts and the advantage is lost.
Many employers encourage their employees to use high deductible health plans by contributing free money to their HSA. In that case, having an HSA becomes a must do in tandem with getting the employer match.
Max out your HSA every year and invest it for as long as you possibly can.
3 Traditional tax-deferred retirement accounts
You may have access to a 401k, 403b, or 457 through your employer. If you are self-employed, you have a couple of Individual Retirement Account (IRA) options with similar tax treatment as well.
As I discussed in Secrets to Getting Money Out of Your Retirement Accounts Early, these accounts are accessible even before 59 ½.
Additionally, I explained in How to Pay Zero Taxes on 401k and IRA Withdrawals that typical retirees who are living on less than they once earned—the definition of saving—will pay much lower taxes than in their working years based on the progressive tax system in America.
The rare exception to this statement occurs when a retiree builds a multi-million dollar tax-deferred account and does not begin withdrawing money soon enough to the point that Required Minimum Distributions (RMDs) are triggered in her 70s. RMDs can push you into higher tax brackets. But proper planning will avoid this.
Pathway to FI readers are big savers, but are not likely to end up with a $10 million 401k before strategically converting it to a Roth or accessing it to enjoy life.
I am confident in putting traditional accounts before Roth for the PathwayToFI community!
4 Roth IRA
The advantage of Roth contributions is that they are accessible to you at any time. This is allowed because you have already paid taxes on those contributions.
I love Roth IRAs, and put as much money as I could into them for many years. They are down to #4 on my list, however, because my Roth contributions were taxed at my top marginal tax bracket while in my prime earning years. As I explained above, I now expect to pay much lower taxes on withdrawals from my traditional 401k and IRA and should have maxed those out first in retrospect.
“Hindsight is 20/20”, as they say.
Some employers also offer a Roth 401k, 403b, or 457. I am not advocating for using those because they are subject to the same contribution limits as your traditional 401k, 403b, or 457. You do not want to take up that space with Roth dollars.
I am specifically talking about a Roth IRA here, which is subject to different contribution limits.
After filling our HSA and traditional 401k buckets, here is how my wife and I have also filled our Roth IRAs.
4.1 Direct Roth IRA Contribution
Direct Roth IRA contributions can be made if your taxable household income is below certain limits. The limits change every year, but can be found easily with a web search.
Don’t forget to do this for your spouse too! You can each contribute to an IRA, even if one spouse does not earn an income.
My wife and I were able to make direct contributions for many years before we needed to use the next method.
4.2 Backdoor Roth IRA
For high earners, a non-deductible contribution can be made to a traditional IRA and then converted to a Roth IRA. This is known as the “backdoor” Roth IRA. Here is an article that provides more detail on executing a backdoor Roth conversion.
4.3 Mega backdoor Roth IRA
After you have maxed out your Roth IRA through the direct or backdoor methods, look into one more path for supercharging your Roth IRA.
Some employees are fortunate enough to have access to the “mega backdoor” Roth IRA. This was discussed in 5 Financial Mistakes that I Have Made in Life.
The mega backdoor has much higher limits than IRA contributions. It involves making an “after tax contribution” to your employer’s 401k, 403b, or 457 and then converting those dollars to a Roth IRA through an “in-service withdrawal”.
Some employer plans even allow same-day automatic in-plan conversions into a Roth 401k instead of a Roth IRA, which gets it out of the after-tax bucket immediately! Check your plan documents or call your benefits department to find out if your employer’s plan allows for these actions.
Do not mistake after tax contributions with Roth contributions. They are above and beyond your traditional and Roth contribution limits, and any growth or dividends are fully taxable within your retirement account. It is not until you make the in-service withdrawal to your Roth IRA that they become tax sheltered.
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4.3.1 Here is an example using 2023 limits:
The employee limit for traditional and Roth contributions to a 401k is $22,500 ($30,000 if you are over 50 years old) in 2023. An employer can contribute above that amount, up to a total employee plus employer contribution limit of $66,000 ($73,500 if you are over 50 years old).
Let’s say you’re younger than 50, the employer’s match equals $5,000, and you max out the employee part of your traditional 401k. You and your employer will have contributed a combined $27,500. This leaves another $38,500 of room ($66,000 – $27,500) in your 401k.
If your employer allows it, you can fill this up with after tax, non-tax-deductible savings. You invest those savings as you make contributions through the course of the year. At the end of the year, your after tax account has grown from $38,500 to $41,000. You then make an in-service withdrawal to your Roth IRA, and have a short-term capital gain of $2,500 for the growth within that year. After the conversion is complete, however, that money is free to grow in your Roth IRA without any additional taxation.
You choose to pay the taxes on the $2,500 capital gain out of pocket to keep the Roth as large as possible. You could also do some tax loss harvesting to offset this gain, however, if you have losses in a taxable account that you can claim that year. More on tax loss harvesting below.
4.3.2 Will the mega backdoor still be around in the future?
Congress has proposed legislation to eliminate the mega backdoor loophole. It did not go through in 2021, but there is no telling what will happen in the future.
If you are saving enough each year to get to the mega backdoor Roth step in the PathwayToFI order of savings, take advantage of it while you still can!
5 Taxable Brokerage Account
Taxable accounts are obviously the least tax efficient of all places to save. There are several strategies that you can use to limit your taxes, however. I will cover some of them briefly here.
Since we are talking long-term savings, we will use a brokerage account where stocks and other assets can be held. Your brokerage could be a low-cost fund provider such as Fidelity, Schwab, or Vanguard.
5.1 Tax loss and tax gain harvesting
Tax loss harvesting occurs when you sell an investment at a loss in order to reduce your tax burden for the year. The loss could either offset another investment gain or reduce your ordinary income. The limit on ordinary income offset is $3,000, and anything beyond that is carried over into a future year.
In order to maintain a similar asset allocation, you can buy a similar investment with the proceeds of the sale. For instance, you might buy a total stock market fund to replace the S&P 500 index fund that you sold. Read this article for more on tax loss harvesting.
There are companies such as Wealthfront that automate tax loss harvesting for you and do it on a more granular level and higher frequency than you would be able to do manually. Wealthfront worked well for me when I was in my peak earning years.
If you create a new Wealthfront account using this link, we will both get $5,000 managed for free.
Tax gain harvesting works in the opposite direction. An investment is sold with a capital gain in order to increase the basis—the purchase price used for calculating a gain or loss—of the shares that you own. This is done in years where you are in a low tax bracket.
As I wrote in How to Pay Zero Taxes on 401k and IRA Withdrawals, the US tax system is currently very generous with the 0% capital gains bracket, allowing many retirees to take advantage of tax gain harvesting. Read this article for more on tax gain harvesting.
This article explains how tax loss and tax gain harvesting can be used together in up and down markets to increase tax efficiency. Harvest your long-term capital gains at the 0% rate, then harvest a loss in a future year on an investment that you have still made money on overall!
5.2 What to hold in a taxable account
Be careful to only hold low turnover funds in your brokerage accounts. “Turnover” occurs when a stocks are bought and sold. Stick with ETFs and avoid actively managed mutual funds that may be buying and selling often, creating unnecessary taxable events.
This also means that you shouldn’t do too much buying and selling of individual stocks yourself unless the sales are with tax loss or tax gain harvesting in mind.
“Our favorite holding period is forever.” –Warren Buffett
Some investments provide dividends that do not qualify for long-term capital gains rates. These are called non-qualifying dividends. The most common asset class with non-qualifying dividends is Real Estate Investment Trusts (REITs), which are included in the PathwayToFI Model Portfolios.
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It’s wise to hold assets with non-qualifying dividends in your tax-advantaged accounts and only those with qualifying dividends in your taxable accounts. Read this article for more details on non-qualified dividends.
5.3 Gift appreciated stock
“Do well by doing good.” –Ben Franklin
It’s true that you can do well financially while being charitable. If you regularly give to charity and also have highly appreciated stock, it’s easy to bring these two things together.
When you give an appreciated stock, the charity can immediately sell it and use the proceeds.
In return, you get a tax deduction for the full value of the stock at the time it was donated. You also avoid having to sell it in the future and pay capital gains taxes. And you can buy the stock back immediately if you would like, getting a step-up in basis similar to tax gain harvesting.
The first thing to keep in mind is that you need to itemize your taxes in order to get the charitable deduction. This means your gift will need to be substantial enough to get above the standard deduction. Many people, including myself, do this today by bunching multiple years of giving into a single tax year. I talked about giving strategies in more detail in Best Way to Give to Charity, Save on Taxes, and Get Lifetime Income at the Same Time.
6 Summary
The PathwayToFI order of retirement savings is repeated below. Fill up each of these buckets before moving to the next. If you get all the way to #5, you are in a category of super savers, and if you are not financially independent yet you will be very soon!
You may be wondering where college savings fit into this equation. This article discusses the college saving topic in more detail.
As always, please contact me directly or on social media if you have any questions or comments.
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