401(k)s are the most common type of savings plan offered by employers. You’ve heard it before – make sure you save money into your 401(k)! The more money you make, the more you should contribute into your 401(k), right? Maybe not.
Most employers offer some type of match on your contributions. Let’s say you make $100,000 and your employer matches your contributions up to 3% of your salary. This means if you contribute $3,000 to your 401(k), the employer will also contribute $3,000 to your 401(k). This is literally free money, or viewed another way, a 100% return on your investment.
It’s important to take advantage of this, but be careful – employer contributions vest over a certain amount of time. You don’t own the employer contributions until it vests. If the employer contributes $3,000 into your 401(k), but only 20% vests in that year, it means you only own $3,000 * 20% = $600.
Once you take full advantage of the employer match, there are other options to save that may be better suited for you. This is based upon the view that you value the flexibility and ability to experience your money throughout your life, as opposed to saving all your money to use in your 60’s. In other words, you don’t buy into the work-until-you’re 65 mentality.
Traditional retirement accounts and IRS rules discourage the use of funds before the age of 59.5, so saving money requires a different approach.
Max out your Roth IRA
Roth IRAs are my favorite savings vehicle. Contributions are after-tax and earnings grow tax-free which is a very powerful tool when you are younger. The tax-free component is great, but I place a greater emphasis on the flexibility that Roth IRAs offer.
Let’s say I contributed $6,000 (maximum annual limit) to my Roth IRA at the beginning of 2019 and that balance grew to $7,800 at the end of 2019 (markets increased 30% so this is actually realistic). My $7,800 Roth IRA contains two components – my $6,000 of contributions and $1,800 of earnings.
I can withdraw that original $6,000 contribution tax and penalty free at any time, for any reason, no matter what. In other words, if I wanted to go to Vegas and put $6,000 of my Roth IRA on black, I can do that.
The IRS rules pertain to the $1,800 of earnings. You can withdraw the earnings tax-free if you reach age 59.5 or a qualifying reason occurs. Now, if I decided to withdraw the full $7,800 when I go to Vegas, I am using Roth IRA earnings before the age of 59.5 which results in a tax and 10% penalty on the $1,800 of earnings. My $6,000 still comes out penalty and tax-free.
People want to start saving, but don’t want to lose complete control over their hard-earned money. This is why Roth IRAs are so powerful – you maintain the ability to withdraw contributions at any time. Traditional IRAs on the other hand (which are pre-tax), incur income tax and a 10% penalty on the full withdrawals if you take money out before the age of 59.5.
Roth IRAs provide you with the flexibility to fund mini-retirements or living expenses if you scale back work before age 59.5.
Max out your Health Savings Accounts (HSAs)
Financial planners nerd out for HSAs because you can actually have your cake and eat it too! Why? Because contributions to HSAs are pre-tax and earnings grow tax-free. It is the only type of investment account that allows you to save on taxes and then invest it with tax-free earnings.
What’s the catch? Two things.
First, in order to contribute, you need to be on a high deductible medical plan. High deductible medical plans have lower monthly premiums, but possibly higher out of pocket medical expenses if you go to the doctor often. For 2020, your deductible must be at least $1,400 for an individual or $2,700 for a family. Many people shy away from this because of the fear of paying more money out of pocket. However, high deductible plans offer guaranteed monthly savings (in the form of lower monthly premiums) and the ability to defer taxes by contributing up to $3,550 for an individual and $7,100 for a family into a HSA. If a family has a combined marginal federal and state tax rate of 30%, then contributing a $7,100 into a HSA saves $7,100 * 30% = $2,130 in taxes. Combine this $2,130 of savings with the guaranteed monthly savings of lower premiums and it may justify the extra risk of paying more money out of pocket.
Second, you must use HSAs to reimburse out of pocket medical expenses. The list of out of pocket medical expenses is very extensive (sorry folks, but medical marijuana is not on this list yet…). The most common expenses are copays, hospital visits, dental treatments, physical therapy, drugs, etc.
The key point is that these reimbursements can come out at any time. In other words, let’s say I made a $3,000 HSA contribution last year and rather than spending it, I invested it in a US equity fund. The HSA would now be worth roughly $3,900. If I incurred $1,000 of out of pocket expenses in 2019 – I now have this “running tab” that I can tap into if I ever needed it.
Now, let’s say I’m going to Vegas again and want to put $1,000 on black. I can use my HSA up to $1,000 tax and penalty free to do this. Why? Because I’m “reimbursing” myself for the medical expenses that I incurred back in 2019.
See how this can be powerful? It’s so important to track your out of pocket medical expenses – it creates this “running tab” that you can tap into at any point, for any reason. You may not have high out of pocket expenses now, but that will certainly increase if you have kids.
Be careful though – if you use a HSA for reasons other than reimbursing medical expenses, you have to pay a 10% penalty and tax on the full distribution.
Save in a taxable account
Taxable accounts are often overlooked because they don’t provide any type of tax deduction or tax-free earnings. Any realized appreciation of investments will be taxed, but at capital gains rates which are lower than income tax rates. If you invest $5,000 into a taxable account and that grows to $6,000, you would be taxed on $1,000 of investment growth when you sell.
However, taxable accounts offer you by far the most flexibility. There are no rules about when you can or can’t use contributions and earnings. You can tap into these funds at any time and for any reason – for a mini retirement, to pay for education, to take a family vacation, etc.
- It’s not enough to save money – you need to save in the right way that allows you to use funds when you want to. This is why traditional money decisions change when you want to experience your money throughout your life, not just in retirement.
- Create a savings order. This will vary for everyone, but a common starting point could be:
- Contribute the minimum to your 401(k) to receive the employer match
- Max out your Roth IRA
- Max out your HSA
- Save the remainder in a taxable account
- Match your investment strategy to the type of account. Here is a good starting visual to use. Remember – this may not be the best decision tax-wise, but it provides you with the opportunity to experience your money throughout your life. A fulfilled life is not paying the minimum amount of taxes, a fulfilled life is living according to your dreams and values throughout your life.
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