I was having lunch with a co-worker a while back, and the exhilarating topic of retirement accounts came up. Our employer offers a generous 50% 401K match, which led me to assert,
“If you have the cash flow to do it, you’d be crazy not to make the maximum 401K contribution.”
co-worker: “I disagree. I would always max out a Roth IRA before contributing to a 401K.”
After further discussion, I gathered that this co-worker thought that Roth accounts have some sort of no-tax super-power to them, which made them superior to traditional retirement accounts.
Not only is this not true – Roths are very overrated – but if my co-worker practiced what he was preaching, he was missing out on thousands of dollars of free money each year. I mean, we’re talking about a free guaranteed instant 50% return!
This is one example of misunderstanding retirement plans, but over the years, I have learned that it is not unique. Why?
- many employers don’t offer 401Ks to their employees, so many people have no experience with them or with retirement accounts, in general.
- words like “Roth”, “Traditional”, “SEP”, and “HSA” have no descriptive intrinsic meaning to them, if you don’t already know what they are.
- there are a lot of options out there and researching each takes time and effort.
- remember that personal savings rates (general average is 5%, millennial average is -2%) are horrible, so people have no savings to contribute to a retirement account. In other words, there is no need to learn what they might be contributing to.
With this lack of knowledge, it is no surprise then that many have no clue as to how they should prioritize their retirement account plan contributions when they actually do collect some savings to contribute.
So, that is what I’ve set out to do here. Rank order, in priority, the best retirement plan accounts (with #1 being first priority). Note that I will not rank order self-employment income retirement account options, as I have already done an analysis at that link. If you do have self-employment income and start up an account (e.g. Solo 401K, SEP IRA, or SIMPLE IRA), then consider them to be on an equivalent level as Traditional IRAs here.
Also, I will jump around a little depending on whether your employer matches your contributions or not.
As a refresher, remember that “Traditional” retirement accounts are pre-tax (tax deductible when contributed), and taxed at withdrawal. “Roth” accounts are post-tax (taxed when contributed and not deductible), and are not taxed at withdrawal. Also, if you have a 403B or other 401K equivalent, the same rules should apply as they do to the 401K.
Retirement Account Rankings, In Order of Contribution Priority
1. Employer HSA with match OR Traditional 401K with match, whichever of the two has the higher return on contribution match, up until you reach the maximum employer match.
2. Employer HSA with match OR Traditional 401K with match, whichever of the two has the lower return on contribution match, up until you reach the maximum employer match.
#1 and #2 are interchangeable, and you should prioritize whichever of the two has the highest return on contribution match. My employer offers an HSA with its HDHP (you can’t have an HSA without an HDHP), but the contribution is an automatic dollar amount, not a match. Many employers, however, offer a matching percentage of contribution or percentage of salary. So go with the one that offers the best return on contribution match. Then move on to the other. Free money always trumps account type, 100% of the time.
3. HSA, with no further employer match, up until the maximum contribution is reached
IF, the return on contribution match is equal, go with the HSA over the Traditional 401K. Reason being is that the two accounts are similar in their properties, with one exception – the HSA has tax free withdrawals for incurred medical expenses. Matching aside, this makes the HSA the best retirement account. Contributions are tax-deductible AND qualified withdrawals are tax-free. Amazing! Note that if you do not spend your funds on qualified medical expenses and you withdraw them in retirement, the properties are similar to a Traditional IRA (you are taxed).
4. Traditional IRA, up until the maximum contribution is reached
The Traditional IRA and Traditional 401K are identical in their taxation. So how do you choose which to contribute to, when there is no further matching involved?
The Traditional IRA is the better account option, because it gives you more control. Traditional 401K administrators and investment options are chosen by your employer, and can leave you severely limited in your investment choices (potentially limiting investment diversification). You may also be left with funds that have high expense ratios, and/or hefty account administrative fees. You can avoid those situations, by simply diverting savings to your own Traditional IRA instead.
5. Traditional 401K, with no further employer match, up until the maximum contribution is reached
For reasons noted in #4, a Traditional 401K with no match is less desirable than a Traditional IRA, due to lack of control.
Also, you’ll notice how I like Traditional IRAs and 401Ks above their Roth counterparts below. I’ve noted why Traditional retirement plans are superior to Roth’s previously, in great detail, but to summarize:
- you’re probably making more now than you will in retirement, so why not get taxed then at a lower rate (vs. now).
- every additional dollar saved and invested now can improve your chances for an early retirement.
- reducing your income (through Traditional deductions) can increase your chances of an ACA healthcare subsidy.
- if you invest $1 in a before-tax account (Traditional IRA, 401K, HSA), that dollar is taxed as the last dollar earned. In other words, it is taxed at your highest marginal rate. When you withdraw $1 from your accounts in the future, it is your first dollar. The first dollar is taxed at 0%.
- it affords you a higher quality of life right now, while life is certain and you are comparatively young and healthy, versus when you are older and have a higher probability of health problems and death.
6. Roth IRA, up until the maximum contribution is reached
Roth IRAs are better than Roth 401Ks for the same reasons highlighted in #4 (they give you more control on investment options and expenses).
7. Roth 401K
Remember, there is no such thing as a “post-tax match”. Roth 401K matching funds are contributed to a Traditional 401K. So don’t think that by contributing to a Roth, your matching funds are also going to the Roth and you will get a larger match (I once had this brilliant and inaccurate idea). Therefore, there is little to no reason to ever contribute to a Roth 401K. Traditional 401Ks and Roth 401Ks share a cumulative maximum 401K contribution amount. You’d be wise to put all of it in your Traditional 401K.
Agree/Disagree? Tell us why.
With this new tax bill coming close to being official being general tax cuts to the tables, (I’m interested in hearing your opinion on it) it will make the Roth more attractive. I like the Roth because my tax bracket will most likely be the same whether now or retirement. However, at least I will have mostly tax-free withdrawals and I’ll have my employer match that’s taxable. My taxes are low given I’m married, one income with one child.
Pretty much every independent assessment of the tax bill says it will add over $1 trillion to the national debt, which has been increasing for years anyways. It’s also incredibly unpopular so a potential repeal by a future Congress/administration may not be as politically difficult as a tax increase would be in other scenarios.
You don’t know what future tax rates will be, and voluntarily paying more today hoping your tax rate in retirement will be lower is a risk. But personally, I think tax rates *will* be higher when I retire, so I favor Roths.
You should mention that many employer 401K plans offer a personal investment option with an outside broker (such as Schwab, Vanguard, etc) that allows the employee to access the same broad and diverse investments as an ordinary IRA.
Good call – wrote about it here: https://20somethingfinance.com/self-directed-brokerage-401k/
I am 26 and in relative good health. Currently making ~37,000/year. I have the option of an HSA but considering I have very low health care costs and the funds are not matched and do not roll over, I do not contribute. I have also been hearing for years that it is a much better option to put in to a Roth vs. Traditional since I am young and *should* be making a higher salary by the time I retire. So my priority up to now has been 1. Employer matched Roth 401K (100% up to 4%) and 2. Individual Roth IRA. This is the first time I have heard that the opposite is true (and I consider myself well-read in personal finance for my age) and it is sending me into quite a panic. If you could clarify or direct me to more resources on why the Roth is not a good option for a young person in their early-career, I would appreciate it! Thank you for all you do – I’m a dedicated reader!
Check out the “Roths are overrated” post I link to in the article. It sounds like you may be in the rare group of those with a lower income (and tax bracket) who actually saves significantly for retirement, where contributing to a Roth makes sense. Don’t panic – it sounds like you’ve educated yourself on this.
Beth HSA does roll over each year. And the beauty of the having an HSA account
is that it works just like a 401K but with one additional tax benefit unlike a 401k in that it allows you to withdrawal the money at any time to pay for medical bills. But the savvy individual will pay all medical bills out of pocket and let the HSA contributions build and grow over time (current year allows you to contribute 3550) without touching. Save the medical receipts and you can reimburse yourself @ the age of 65 when these HSA contributions are no longer allowed.
Love this order of operations. 401Ks charge a lot of money but many colleagues of mine think they’re “free” since they don’t get a bill or notification for fees. Even the cheapest 401k is significantly more pricey than a regular old Traditional IRA from Vanguard.
I agree with the list, but I would add that one advantage that Roth’s have is that you can withdraw your contributions after 5 years. While I wouldn’t use it as an emergency fund, it’s nice to have those funds available and be a little more liquid if needed. But as far as tax breaks Traditional is still much better.
Can you max out both a 401k and a Roth IRA?
You sure can. I have been doing this strategy for 4 years now. I like that it gives me diversity in my retirement accounts.
The difference between Roth versus Traditional depends on your tax rate today and your future tax rate at withdrawal. The factors which change your tax rates are as follows: where you live, when you would like to access the money, the withdrawal amount, and changes in tax policy. You will probably be in a higher tax bracket if your money is invested in stock like the S&P 500 for a long period of time (over 33 years at max contribution for Roth IRA), so a Roth might be better in this scenario. In addition, federal tax rates will probably be higher in the next 30 years due to the growth of government debt. Therefore, my rule of thumb is to invest your money in Roth if you will not touch it for 33 years and at least invest enough money in stock to max out a Roth IRA (if you plan to retire in the same state). Otherwise, I believe traditional is better for you.
However, you can choose to live in a state with no state income tax at retirement, which can make traditional a better option. For instance, California has a state income tax rate of 13.3% and Nevada has no state income tax. Therefore, you could save 13.3% if you moved to Nevada in retirement from California and then withdrew your money from a Traditional retirement account. If you would like to retire before 59 ½, it can make sense to invest some of your money in Roth because a Traditional retirement account would be penalized 10% for early withdrawal. For a Roth, you can withdraw the principle without penalty if the Roth has been established for 5 years.
One thing I didn’t see commented on was RMD’s for all these accounts. This may be less impactful for people who aren’t big savers, but I am guessing a lot of people on this site might save a little more than average. If you look at RMD’s that kick in after 70-1/2 they start at reasonable rate (~4%) and then really ramp up as you pass 90. (Note: calculation is based on simple formula, but it is not percent so calculate your personal RMD). Everyone’s health picture is different, but I prefer being conservative with this estimate of how long you live and if you save millions you are going to see LARGE requires distributions at significant margin rates. HSA’s, in addition to tax free for qualified expensives, have no RMD’s. How awesome is that?! My personal assumptions on future tax rates (based on our government fiscal management… or lack there of) along with my personal health estimates mean I really have to worry about RMD’s and have me more supportive of Roth and other methods to avoid tax on earnings growth.
The emergency fund-component of Roth accounts is what makes them particularly valuable. I am 23, and I see coworkers of mine contributing into HSA’s and 401ks, with little other savings. In your 20s and 30s, buying homes//making big career moves//having children are all capital-intensive decisions. The added comfort of being able to withdraw Roth contributions tax and penalty free makes these accounts attractive until a person’s net worth is >100k+. Having a majority of your net worth locked up in restricted accounts can unnecessarily put you in a bind and lead you to paying hefty penalty fees.
I absolutely agree with #1 and #2. There’s simply no better return on investment than matching contributions. However, my #3 is the Roth IRA. Traditional IRAs are lacking in 2 areas:
1. We don’t know what the future tax rates will be, leaving yourself open to risk. I know what the tax rates are now so I can plan accordingly. Peace of mind. Additionally, I believe rates will most likely increase in the future due to rising gov’t debt. Don’t leave your future in the hands of lawmakers with debts to pay.
2. Distributions from Traditional IRAs count as provisional income, and thus count toward your social security tax. 85% of your social security tax can be taxed based on the amount of your provisional income.
The argument that you make less in retirement is a fallacy. What aspect of your life are you prepared to give up? In fact, data shows most people in retirement retain 85% of their earnings through social security, IRA/401K distributions, part time work, etc. Distributions from your traditional IRA will most likely be taxed the same or possibly more than they would be right now in a Roth and they will add to getting your social security taxed. The only money that should be going into traditionals is up to the point where RMDs won’t trigger provisional income. (Right now it’s $25,000 for married) I will be getting a pension so my traditional contributions are precisely zero. Roth 401ks are slightly worse than Roth IRAs because the distributions still count as provisional income, although the contribution limits are better. So for those getting pensions, the order should be:
1. Matched contribution accounts
2. Roth IRA
3. Roth 401k
4. Traditional IRA
5. Traditional 401k.
For those without pensions and desperate for tax breaks today, traditional IRA could be moved up to #3, up to the point where there is enough $ in the account that the RMD will start triggering social security taxation. This is a somewhat obscure calculation that will probably change by the time most people retire. My advice, just go Roth and not have to worry about what lawmakers will do with your retirement $.
The IRS limits for 2019 and 2020 is $6,000 for both the traditional and the Roth IRA combined.
In your priority order why fill up Traditional IRA first? you can’t add more to Roth IRA after that? It looks like either-or choice between the traditional and Roth IRA. What am i missing here?
The 2 share a contribution limit together, but you can contribute to both if you want. I prefer Traditional over Roth for the reasons I’ve highlighted.