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 (i.e. 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.
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