Milestone 5: Save 15%-25% in Tax-Advantaged Retirement Accounts
If you’ve reached Milestone Five on the Next Dollar Roadmap, then you’ve come a long way.
You now have plenty of emergency funds.
Your debts, if any, should be on appreciating assets and have low-interest rates.
Finally, you’re enjoying the benefits of your employer’s matching dollars.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
Milestone five is saving 15%-25% of your income in tax-advantaged savings vehicles.
Some of this will be a repeat of information we passed along from Milestone 2, but we want to get all of the relevant information for Milestone 5 in the same post.
The reason you want to take advantage of tax-advantaged accounts is the potential savings over time can be enormous.
Let’s jump right into an example so you can see what we’re talking about:
Joe Dollar
Joe Dollar has completed Milestones 1 thru 4, including his company’s 6% match, and is debating whether or not to max out the remainder of his 401(k).
Joe’s salary is an even $80,000, so in 2022 this means Joe is already putting $4,800 of the maximum $20,500 available into the 401(k).
Let’s look at the financial implications of directing an additional $15,700 into the 401(k) versus investing it in a taxable brokerage account.
We will assume Joe is in the 22% income tax bracket, the 15% long-term capital gains bracket, and that he will be in the same tax brackets no matter when he withdraws the money.
We will also only track the value of the $15,700 he contributes in 2022 to keep it simple.
Finally, we will assume an annual return of 10% on Joe’s investment for both possibilities.
As we evaluate Joe’s options, remember that the principal joe places into his account will ultimately be taxable as income either way.
If he accepts the income and then places it into the taxable brokerage, he will pay income tax on the $15,700 now.
If he puts it in the 401(k) the $15,700 will be taxed when he withdraws it in retirement.
This would be true for a Roth 401(k) contribution too, but we won’t be using the Roth as an example because it doesn’t really change the ultimate point and the end result is the same for Roth or Traditional when income tax rates and interest rates remain constant.
As a result, the real difference will be in the gains or growth of the asset above $15,700 over time. Let’s further assume Joe will withdraw his investment in 20 years and see what the overall impact of taxes is in each situation.
Joe’s 401(k) Option:
Assuming Joe puts the additional $15,700 into his 401(k) none of the money is taxed going in, so he receives the full benefit of investing $15,700.
In 20 years, Joe will have $105,621.75 before taxes. After paying 22% income tax on the withdrawal, Joe’s $15,700 has turned into $82,384.96.
Joe’s Taxable Investment Option:
In this scenario, the $15,700 principal Joe could have put into his 401(k) is now worth $12,246.00 after he has paid income tax.
In 20 years, this amount grows to $82,384.96 before taxes. Once Joe pays a 15% long-term capital gains tax on the growth beyond his initial deposit [($82,384.96-$12,246.00) x 0.15 = $10,520.84 in gains tax] he has a total of $71,864.12.
In summary, forgoing the option of using his tax-advantaged 401(k) would cost Joe an additional $10,520.84 in capital gains tax when he withdraws the funds in 20 years.
Put another way, assuming everything else stays the same, the cost of going the taxable route is equal to your long-term capital gains rate.
Currently, this is 0%, 15%, or 20% depending on your income tax bracket. (Note: Long-term capital gains apply to assets owned for at least one calendar year. Short-term gains are taxed at your normal income tax rate.)
The 401(k) is just one example of several tax-advantaged options available to Americans in order to encourage saving for retirement. Let’s walk through some other popular plans and share some of the details of each.
HSA
The Health Savings Account (HSA) is primarily known as a vehicle for saving money for qualified medical expenses, completely tax-free.
The unique feature HSAs possess that differentiates them from FSAs or HRAs is the ability to invest the money in the account, similar to other retirement plans like 401(k)s or IRAs.
Funds deposited into HSAs are (i) not subject to federal income tax, (ii) can grow tax-free, and (iii) if withdrawn to pay for medical expenses are tax-free upon disbursement.
This trifecta of tax avoidance is known as “triple tax-advantaged” and is the only investment account with this feature.
Furthermore, if money is placed into a company-sponsored HSA directly by your employer, those dollars also avoid Social Security, Medicare, and Federal Unemployment taxes.
You must be covered by a High Deductible Health Plan or HDHP to be qualified to make contributions to an HSA.
The requirements for HDHPs change annually, but for 2022 the minimum required deductible was $1,400 for singles ($2,800 for families) and the maximum out-of-pocket was $7,050 for singles ($14,100 for families).
Obviously, there is more risk for the insured in an HDHP, but premiums are generally much lower for HDHPs.
If you are in relatively good health and you have the option, an HDHP combined with an HSA can be a very effective way to manage healthcare expenses.
The maximum contribution amount into an HSA for 2022 is $3,650 for singles and $7,300 for families. Individuals 55 or over can place an additional $1,000 “catch-up” amount into the account annually.
These limitations include any money placed into the account by your employer, so be sure to take that into account when calculating your annual deposit.
Another feature of HSAs is the ability to use the money in the account in retirement for expenses that are not for medical needs.
If you become disabled or turn 65 you can withdraw funds from the HSA for non-qualified expenses penalty free, but they will be subject to regular income tax.
Funds withdrawn for non-qualified expenses before the age of 65 are subject to a hefty 20% penalty in addition to regular income tax.
One notable limitation of HSAs is their lack of flexibility in estate planning. While spouses can continue to use an inherited HSA from their deceased husband or wife, any other heirs will realize a taxable event for the entire HSA balance at their regular income tax rate in the year the HSA is inherited.
Since death isn’t an event you can typically plan for and the inheritance can’t be spread out over an extended period like an inherited IRA, this could create a heavy tax burden for your heirs if you fail to use the funds in the account efficiently before you pass away.
Other notable HSA characteristics or hacks:
- If you have an elective medical procedure that can be delayed until a subsequent calendar year, you can enroll in a different health plan to time the expense so it isn’t incurred while you’re enrolled in the HDHP.
- Your employer may or may not offer an HSA and may or may not contribute to it. If you are in an HDHP you can open an HSA with most investment companies like Fidelity or Vanguard.
- We use an HSA and hold a cash balance in the plan high enough to cover deductibles. Many accounts will require you to hold some minimum amount in cash.
- If you can afford to pay for medical expenses out of pocket it is a more efficient option because it allows funds in the account to continue to grow for years undisturbed. Just save receipts for those expenses and reimburse yourself at a later date. There is currently no limitation on how long you can wait to reimburse yourself.
401(k)/Solo 401(k)
A 401(k) is an employer-sponsored defined contribution retirement plan that allows participants to direct their income into an investment account tax-deferred.
This means all deposits grow unhindered by taxes until funds are withdrawn at retirement and taxed at regular income tax rates.
Anyone can participate in a 401(k) assuming one is provided by their employer, regardless of their income.
Note: There are some restrictions if you are defined as a “highly compensated employee”. You should investigate this if you work for a small company and earn a high income.
The IRS allows you to contribute up to $20,500 tax-deferred in 2022 and if you’re 50 or older there’s a $6,500 catch-up provision allowing you to deposit up to $27,000 total.
Any employer contributions do not factor into this amount.
In addition to your tax-deferred contributions, some plans may allow you to contribute after-tax dollars to the 401(k).
The 2022 max total contribution is $61,000 ($67,500 for those 50 or older) for all 401(k) deposits including any employer deposits. Only the gains on these contributions would be taxed upon withdrawal.
One attractive strategy that you can pair with this after-tax contribution is the backdoor Roth IRA which can allow higher income earners access to a Roth IRA even if they are otherwise disqualified due to income restrictions.
This process requires effective planning and takes a few steps, so look carefully into the details if you’re interested.
If at some point you elect to remove your 401(k) dollars you will pay a hefty 10% penalty in addition to income tax on the distribution. As a result, it doesn’t make sense to use this money until retirement unless you are out of other options.
401(k) funds are not eligible for withdrawal until age 59.5 unless you retire or are laid off from the company that manages the plan. In this case, you may be able to begin distributions at 55 without penalty.
This is known as the rule of 55 and is important to keep in mind if you plan to retire before 59.5.
Bear in mind as you consider this that you must leave your employer in or after the calendar year in which you turn 55. You cannot retire at 52, then tap these funds when you reach 55.
Beginning at age 73, you must begin taking Required Minimum Distributions (RMDs) out of your 401(k) so the funds in the account can be taxed.
This can be significantly inconvenient if you’ve managed to accumulate a large balance in your account.
There are ways to mitigate this through Roth conversions or Qualified Charitable Distributions (QCDs), but you’ll have to convert to an IRA first.
Usually, 401(k) owners elect to transfer their accounts into an IRA before age 72 to consolidate retirement money and allow for more flexibility in managing the funds.
Solo 401(k)’s are similar to 401(k)’s but available to business owners and their spouses that work in the business.
Many of the rules governing deposits and withdrawals are the same, but you cannot combine the two plans and get a double 401(k) if you happen to be employed and own a small business.
IRA
An Individual Retirement Account or Arrangement (IRA) is a tax-deferred retirement account available through nearly any investment company and owned solely by the account holder.
Like a 401(k), IRA contributions get to grow tax-free until withdrawals are made and taxed as regular income.
In 2022, Individuals can deposit $6,000 per year ($7,000 if 50 or older) into an IRA assuming they have at least that much in earned income. Contributions are tax-deductible.
Anyone can contribute to an IRA, but there are income restrictions for claiming a deduction on your taxes.
Withdrawals made from an IRA made before you turn 59.5 also come with a 10% penalty in addition to regular income taxes.
Required Minimum Distributions (RMDs) must be made when you turn 72. RMDs can be managed through Roth conversions or Qualified Charitable Distributions (“QCDs” covered in Milestone 9).
In addition to options managed through investment companies, self-directed IRAs provide a litany of options for investing IRA funds through other businesses, assets, or real estate.
There are a lot of restrictions on this type of IRA, so be sure to carefully investigate the circumstances of your own situation.
457 Plans
457 plans are similar to 401(k) plans in that contributions are made through deferred income which is placed into an account that can then be used for investing on a tax-deferred basis.
457 plans are not available through for-profit employers but are common in state and local governments as well as some charitable organizations.
In 2022, employees can contribute up to $20,500 per year to a 457 plan or up to $27,000 if they are 50 or older.
Additionally, 457s offer a unique double catch-up provision that allows participants to retroactively fund the account for years in which they were eligible to contribute to the plan but did not elect to do so.
Unlike 401(k)’s, contributions made to the account by an employer count against the annual limit. So, if your employer deposited $5,000 into your account in 2022, the maximum you could contribute if under 50 would be $15,500.
One major advantage of 457’s is that contributions do not count against contributions to a 401(k) or 403(b).
As a result, you can fully fund a combination of these tax-advantaged retirement accounts in a single year if you’re able. (But only the 457 with another account. You can’t double up a 401k and 403b.)
Another great benefit of 457s is once account owners retire or become disabled, there is no age minimum for making withdrawals from the accounts.
Since many account holders are public servants that may hold jobs which take a unique physical toll and might force earlier retirement.
The idea is to allow access to this pool of retirement funds if participants choose to step away earlier than most.
403(b) Plans
Usually offered to public school employees, 403(b) plans work in many ways like a 401(k). The contribution limits and catch-up provisions are the same, as well as the eligible withdrawal age of 59.5.
Withdrawals made before age 59.5 are subject to a 10% penalty in addition to regular income taxes. The rule of 55 also applies to 403(b) plans.
Combined employee and employer contributions are also limited to $61,000 in 2022 just like 401(k)’s.
One unique feature of 403(b) plans is after 15 years of service to the same employer, plan participants can contribute a special catch-up contribution of up to $3,000 per year, not to exceed $15,000 total. You do not have to be 50 or older to take advantage of this catch-up option.
Unfortunately, investment options in a 403(b) are more limited than 401(k)’s. The only investments available are fixed or variable annuity contracts and mutual funds.
Typical investments like stocks and Real Estate Investment Trusts (REITs) are forbidden.
It is possible to have both a 403(b) and a 401(k) plan, but participants are limited to a total combined contribution of $20,500 annually (plus any applicable catch-up amounts).
Roth vs Traditional
All of the aforementioned plans, aside from the HSA, may be available as a Traditional tax-deferred account (as they are all described above) or as a Roth.
Roth accounts primarily only change the manner in which the contributions and/or withdrawals are taxed in all of these circumstances.
Employers are not legally obligated to provide both a Roth and Traditional option of 401(k)’s, 403(b)’s, or 457’s, but they are much more common than they were formerly.
Historically, dollars deposited by an employer would have always been treated as if they are Traditional funds, regardless of whether the employee’s deposits are made to a Roth-type account or not. This is because your employer receives a tax benefit for their contribution in the year it was made.
However, with the passage of Secure 2.0 in December 2022, employers will be allowed to make contributions to employee accounts in the form of an after-tax or Roth contribution. Employees will owe income tax on these contributions, but this is a significant change to employer contributions.
While contributions to tax-deferred accounts are tax-free and later taxed upon withdrawal at the participant’s income tax rate, in a Roth account the contributions are taxed and withdrawals are made tax-free.
You might wonder why this matters; and if your tax rates and investment returns are the same when you contribute and when you withdraw, it doesn’t.
Let me state that again another way, If you have the same tax rate when you put money in an account and when you withdraw it, the net result after all taxes are paid will be exactly the same.
As a painfully simple example, let’s suppose you have $1,000 to invest. You receive a return of 10% and have an income tax rate of 20%.
In a Roth, you contribute $800 and send $200 (20% of your $1,000) to Uncle Sam. Your investment gains another $80 in one year (10% of $800) and you net $880.
In a Traditional scenario, you contribute all $1,000 to the account. Your investment gains $100 more (10% of $1000) for a gross total of $1,100. You pay $220 in income tax (20% of $1,100) and you net $880.
You can expand this with larger dollars, longer years, and other rates of return, but as long as the tax rate and investment return are equal the end result will always be exactly the same.
So, ultimately, since rates of return cannot be predicted with certainty and you’re likely to base your asset allocation on age rather than the account type, the optimal decision depends on your tax rates at the time of contribution and withdrawal.
If you are in a lower tax bracket when you contribute than you will be when you withdraw, you should use the Roth.
If you are in a higher tax bracket when you contribute than you will be when you withdraw, you should use tax-deferred routes.
Now you might be thinking, “but I don’t know what my tax rate will be when I withdraw”.
And there’s the rub.
Volumes have been written in debate over this topic. I’ll give my point of view, but feel free to go another route it if you disagree. No one knows the future, so no one is wrong until it’s too late to change course anyway.
- I prefer to go with what I know. I know what my tax rate is today. In the future, I hope my income and assets are high and I’ll have a hard time getting into a lower tax bracket.
- I also know we’re currently sitting at historically low-income tax rates.
- Additionally, the government doesn’t seem interested in slowing any of its spending habits. Taxes are only likely to go up or at best remain the same in the future.
- As a result, in years that we fall into the 24% federal income tax bracket or lower, we contribute to Roth options. I might alter this a bit if I lived in a state with higher income tax. Currently, my state and federal combined marginal tax rate is 29%. This means I’m assuming my marginal tax rate in retirement will be equal to or lower than 29%.
You may feel differently, and if so, think about the marginal rate tipping point that works for you.
Other Roth Features:
- There are income limitations that prevent people from contributing to Roth IRAs at a certain point. In 2022 the option to contribute to a Roth IRA begins to phase out at a modified adjusted gross income (MAGI) of $129,000 if single or $204,000 if married filing jointly.
- There are no income limitations for contributing to a Roth 401(k), 457, or 403(b).
- Even if you are restricted from contributing to a Roth IRA due to income limitations, you can contribute to a Traditional IRA with after-tax dollars, then convert the dollars over to a Roth IRA. This is known as a Backdoor Roth IRA. Be sure to look up the pro-rata rule before doing this! If you already have other IRAs you will be taxed on a pro-rata basis for all of them when you do the conversion.
- If your employer allows for in-service withdrawals, you may be able to contribute after-tax dollars up to the annual $40,500 limit above the $20,500 tax-advantaged portion, then roll those contributions into a Roth IRA. This is known as a Mega Backdoor Roth and is a really exciting option if you have the resources to do it.
- Roth contributions can be removed at any time, penalty-free. Note, the word “contributions”. Withdrawal of any earnings above the contribution is subject to an early withdrawal penalty. Even so, don’t tap those contributions unless you have no choice. You can’t put them back later.
- You can use your Roth IRA to help fund your “first” home purchase, penalty-free, but there are some restrictions. The IRS has a loose definition of “first” home, so check that out if you think you might want to do this, even if you’ve owned a home previously.
- Inherited Roth IRAs are tax-free to your heirs, but they still have RMDs.
- There are no Required Minimum Distributions with Roth IRAs. Until recently, RMDs were required for Roth 401(k)s, but that is no longer the case.
How Should I Prioritize Contributions to These Accounts?
If you have any matching or free deposits to these accounts available from an outside source like an employer contribution, you should have taken advantage of that free money already in Milestone 2.
- Assuming you’ve completed that step, I’d personally start with the HSA if it is available. You can’t beat triple tax savings, which isn’t available through any other tax-advantaged account.
- After the HSA, I’d go to the 457 if available. The reason is the flexibility of the early retirement withdrawal combined with tax-advantaged growth. All other tax-advantaged accounts are off limits to penalty-free withdrawals (with some complex exceptions) until 55 or 59.5.
- Once you’ve filled up the 457, I’d move on to the IRA. Generally, you have more control over an IRA than any of the four hundred plans (401(k), 403(b), or 457). That’s because you can open an IRA with whatever investment company you prefer. This gives you the power to select low-cost investment options and you’ll have more control over which assets you have in your account.
- Finally, after the IRA space is full, move on to the 401(k) or 403(b). These are the last of the available tax-advantaged options, but they’re still full of opportunity.
Why Save 15%-25%?
You don’t really have to stop at 25%, but there comes a point where your current standard of living suffers more than it should for the sake of a fatter and fatter retirement.
What if you break your neck trying to max out every dollar of tax-advantaged space, living like a miser in the meantime, only to die young or have a retirement severely limited by a health issue?
Use this range as a guide. Your life will place varying levels of demand on your finances. You need to be able to calibrate it without going to an extreme in either direction.
Go ahead and put some flexibility in your saving now so you can adjust for whatever life brings your way.
My wife and I have saved anywhere from 14%-25% annually since we got married. This has been more than enough for us, but we did start in our early twenties.
If you’re getting a later start, we’d err on the higher end of this range. The younger you are, the more time you have to account for less saved and you can save closer to 15%.
With that said, if you have the capability to maximize any or all of the accounts above, they will always beat taxable investments in the long run.
There just aren’t many people earning enough income or sacrificing enough to make this happen. But those who do reap enormous benefits over time.
Next stop, Milestone 6: Invest for Flexibility
