Rishi Dhanaraj

Step 2 of 5: What Retirement Accounts To Use

Rishi Dhanaraj -

‍This guide is still under construction.‍

Welcome to my investment series, where I share how to invest in index funds in less time. See the index for the other articles.

In this article, we compare and contrast the available retirement accounts. We learn which accounts to prioritize.

By the end, aim to complete the following sentence stems:

I will contribute to the following accounts in the following order:

1. __________. Maximum contribution ______.
2. __________. Maximum contribution ______.
3. __________. Maximum contribution ______.
4. __________. Maximum contribution ______.
5. __________. Maximum contribution ______.

Reasoning for order:
_______________________________________________________________________________________________________

(In the next article in the series, we talk about how much to allocate to investing, and decide to what extent you can max out your accounts.)

These sentence stems are part of the worksheet that accompanies this investment series. You can make a copy of the Google doc, which can be found here.

OK now let’s get started :)

My Recommendation

First, if your employers matches part of your 401(k) contribution, max out that match.

Then, max out a Roth IRA. If you make more than $140,000, do a backdoor Roth IRA .

Then, max out the rest of your 401(k).

Then, contribute what you can to your regular taxable accounts.

Read on for nuance/details.

What are retirement accounts?

Retirement accounts are accounts that (1) have tax advantages and (2) help you save for retirement.

First, money in retirement accounts grows tax-free.

Over the years, putting your money in a taxable account vs. a tax advantaged account makes an enormous difference.

See this chart:

This all fine and dandy, but what's the catch? Well, once you put money into these accounts, you can't touch it again. If you take money out before you’re 59 ½, you’re penalized.

In some ways this is not a bug but a feature—it encourages you to not touch your retirement savings.

One more thing. Depending on the type of account, you might be taxed at contribution time (when you contribute money to the account) or at distribution time (when you receive a distribution from the account in retirement). More on this soon...

What are the types of retirement accounts?

There are three main types: 401(k)’s, Traditional IRAs, and Roth IRAs. Then there's the Backdoor Roth IRA.

401(k)

401(k)’s are investment accounts offered by employers, unlike IRAs, which are Individual Retirement Accounts. You can contribute up to $19,500 per year.

Some employers will match a part of your contribution, doing what is referred to as 401(k) matching.

Know that in a 401(k), your money is not taxed at contribution time but taxed at distribution time*:

Contributions to a 401(k) are pre-tax, meaning they are deposited before your income taxes are deducted from your paycheck.

However, when in retirement, withdrawals are taxed at your then-current income tax rate.

—Investopedia

Say you have an income of fifty thousand dollars and you contribute five thousand dollars to your 401(k). Then you pay income tax on only forty five thousand dollars for the year.

But later, when you withdraw the five thousand dollars and its gains, you pay income tax on what you withdraw.

When you leave your job, your 401(k) will be rolled over into a traditional IRA.

*Technically, there are both traditional and Roth 401(k)’s but we’re referring what to most employers provide, which is the former.

Traditional IRA

A traditional IRA is one of the two types of Individual Retirement Accounts, or IRAs.

You can contribute up to $6000 to the IRA type of your choice per year ($7000 if you’re over 50). Well, mostly, Roth IRAs have some contribution limits for high earners, more on that soon.

Traditional IRAs, like 401(k)’s are taxed at distribution time (contributions are pre-tax, withdrawals are taxed).

Fun fact, you can withdraw up to ten thousand dollars from a traditional or Roth IRA for the purpose of first time home buying without penalty.

Roth IRA

A Roth IRA has two main differences from a traditional IRA.

1. You’re taxed at contribution time, not at distribution time

2. You have different contribution limits based on your income

First, unlike a traditional IRA or 401(k), a Roth IRA is taxed at contribution time (contributions are taxed, withdrawals are tax-free).

For young people, a Roth IRA is the better move, because you’ll almost certainly be in a higher tax bracket when you are retired and need distributions.

Ramit Sethi, the personal finance blogger, on Roth IRAs:

Though there are advantages to both IRAs we highly recommend you get a Roth IRA.

He continues:

If Roth IRAs had been around in 1970 and you’d invested $10,000 in Southwest Airlines, you’d only have had to pay taxes on the principal amount. When you withdrew the money 30 years later, you wouldn’t have to pay any taxes on it…

…which is good because that $10,000 would have turned into $10 MILLION.

Roth IRAs are a little overpowered which brings us to the next point…

There are income limits for Roth IRA contributions. If you make between $125,000 and $140,000, you have to contribute to Roth IRAs at a reduced amount. To calculate your contribution limit, follow this formula on this webpage by the IRS.

Be careful not to over-contribute. You can get fined a hefty 6%.

If you make over $140,000, you aren’t eligible to contribute to a Roth IRA—but you can do a backdoor Roth IRA...

Fun fact: since you’ve already paid taxes on your contributions, you can withdraw your contribution (but not its gains) tax-free. Put another way, you can freely withdraw your principal, which can be real handy in case of emergency.

Backdoor Roth IRA

There is a way to contribute to a Roth IRA regardless of income.

Follow these steps:

  • Put money in a traditional IRA
  • Convert the account into a Roth IRA
  • Pay the required taxes
  • Enjoy the tax-free gains in your Roth IRA 🤗

The IRS allows one Roth IRA conversion per year, and so this is entirely sanctioned.

Investopedia does point out you can’t withdraw your principal like you would in a Roth IRA though:

The funds you put into the Roth are considered converted funds, not contributions.

That means you have to wait five years to have penalty-free access to your funds if you’re under the age of 59½.

—Investopedia

Though that's not much of a dealbreaker.

That's the last type of retirement account. Now you'll want to know the order in which to contribute to your accounts.

In what order should I contribute to my accounts?

Here is a complete list of the order in which to contribute to your accounts:

  1. Emergency fund
  2. 401(k) match
  3. Credit card debt (average of 16% interest rate)
  4. High interest rate debt (6+%)
  5. HSA (Health Savings Account)
  6. IRA (traditional or Roth)
  7. 401(k)
  8. Lower interest rate debt (4-5%)
  9. Mortgage

This list is sorted by expected return (and in some cases, expected savings on interest rates). You could probably reason through why things are ordered the way they are.

If you're going with a Roth IRA, it should be clear why that comes before contributing to your 401(k). Because we like those tax advantages more (being taxed at contribution time rather than distribution time).

The full reasoning of this ordering is in this excellent article by MyMoneyWizard.

Decisions, decisions

Here are those sentence stems to fill out again:

I will contribute to the following accounts in the following order:

1. __________. Maximum contribution ______.
2. __________. Maximum contribution ______.
3. __________. Maximum contribution ______.
4. __________. Maximum contribution ______.
5. __________. Maximum contribution ______.

Reasoning for order:
_______________________________________________________________________________________________________

Make your decision, and write it down. Then proceed to the next step: What Investing App To Use.