There is some debate around where you should be putting the money you are saving. I plan to delve deeper into the after tax vs tax-advantaged accounts debate in a later post. Here I will focus on which accounts are best to put the money you have specifically set aside for retirement into. I won’t be going in-depth on the types of accounts are or how they work, so if you see something you don’t recognize, you can click on the section header for a link to the explanation.
1. 401k – Up to your Employer Match
This should universally be the first piece of retirement advice anyone gives you. Your employer is offering free money on the condition you save for your retirement. The very first dollars you are able to save should go toward matching whatever percentage your employer offers to match. In addition to the free money, you get the added tax benefit of investing in a 401k – lowering your adjusted gross income (AGI), which is used to determine how much you pay in federal and state taxes.
After you’ve met the company match every other option I will tell you about it up for debate. There is no right or wrong answer after #1. You can continue to add additional money to your 401k past the employer match (up to the 401k limit) and do nothing else and you’d still have a leg up on the vast majority of the population. I wanted to call this out specifically because of the sheer number of articles I see on the internet telling you the top things to do with your retirement money. How you need to do this, and that, and the other. The number of those that don’t start out with – and emphasize – “meet your employer match!”, alarms me.
Before I continue, I want to say that if you stop reading this article right here and allocate all of the money you are able to set aside for retirement to a 401k you’ve already won and I’ve accomplished what I am trying to accomplish.
2. HSA
The HSA is the gold standard of tax avoidance – it’s the only option out there that is triple tax-advantaged. Unfortunately it is the least utilized of all retirement accounts. The reason for that is twofold. First is it’s not technically a retirement account. It is a health savings account. Second, not everyone can take advantage of an HSA. You are only eligible to contribute to an HSA if you participate in a high-deductible health plan (HDHP). I won’t go into the details of HDHPs here, but they generally make the most sense for young, healthy individuals.
So what makes the HSA the gold standard? Like a 401k, you can deposit pre-tax dollars. You are still getting the full advantage of reducing your AGI. Like most retirement accounts, your earnings are not taxed. The real kicker – and what makes this type of account top my list of non-free money accounts – is neither are your withdrawals. In effect the government is never getting a penny of any money you put into an HSA.
Sounds too good to be true right? Well, there are a couple of major caveats. The first is the amount you are allowed to contribute is relatively low. Individuals can only contribute $3,500 a year into an HSA as of 2019. The good news is they do up that number occasionally to account for inflation. The second, is you can only withdraw money penalty free for qualified medical expenses. To avoid going to down a rabbit hole, I won’t go into detail on those, but in general most medical expenses qualify. You can look up a full list here – ADD link. One I will call out specifically is that COBRA premiums do count a qualified medical expense – which is a major reason I personally elected to continue with COBRA after leaving my corporate job, despite the fact I could likely find cheaper private insurance.
The way you turn the HSA from just a really awesome account for medical expenses into a retirement account is to pay qualifying expenses out of pocket (if you can afford to do so) and be diligent about saving your receipts. There is no time limit on withdrawing the money from your account when you have a qualified medical expense. So in theory you could start save receipts early in life, letting your HSA compound completely tax free, then withdraw up to the amount of the receipts you have saved at any time in the future, for any reason and with no penalties or taxes.
3. Roth IRA
There are two main considerations when deciding between Roth vs Standard IRAs. The first is the taxes now vs taxes later question. When you opt to invest in a Roth you are opting to pay taxes now so you do not have to pay taxes later. A good reason to do that is if you think taxes will be higher when you retire than they are now.
The second reason to consider is whether or not you have a comfortable safety net already in place. Of all retirement accounts, the Roth IRA is the most accessible if you do ever need access to the money before age 59 1/2. Because the money is after-tax, you can withdraw an amount equal to your cumulative contributions and don’t have to worry about any penalties like you would for other types of retirement accounts.
Let’s assume you contribute $20,000 to a Roth IRA over a 4 year period (the maximum contribution for 2019 is $6,000), and over that time your account value grows to $30,000. You are able to take out $20,000 at any time you need. Down payment for a house, medical emergency, interesting investment opportunity. The reason doesn’t matter. You have access to that $20,000 if you were to ever need it.
Conclusion
At the end of the day, as long as you are saving money for retirement somewhere you are on the right track. If you take advantage of these 3 retirement accounts, you can get yourself into the fast lane.