Where Do I Put All of This Money!?
Once we’re on board with saving money and getting down with our frugal selves, the question becomes, “What do I do with these savings?” With the large variety of retirement account options available, it can be confusing knowing where to put your hard-earned cash. In this post we’ll explore the available options for retirement savings and discuss effective strategies for how to allocate your savings across different account types.
Account Overload
In a previous post, we discussed the concept of Financial Independence (or FIRE) and how the time required to achieve FIRE depends only on 1.) The percent of your after-tax income you save and 2.) the percent you increase your income/savings each year. If you haven’t read that post, I encourage you to take a look here before going further.
Before we talk about where to put your money, let’s quickly review the options.
- 401(k) – This is an employer-sponsored retirement account which allows employees to set aside a portion of their earnings in a tax-advantaged account. Many employers contribute a matching amount when employees participate in the plan. This type of 401(k) is tax-deferred, meaning that you don’t pay taxes on the money you contribute, but when you withdraw the money in retirement it counts as regular income.
- Roth 401(k) – This is the Roth flavor of the 401(k) above, meaning that you pay tax on your contributions, but the money you contribute grows tax-free. You do not pay tax on the contributions or the earnings when you withdraw them in retirement, assuming you are at least 59.5 years old.
- Traditional IRA – This is an individually-sponsored retirement plan available to everyone with earned income. This is similar to a 401(k) in that you do not pay tax on your contributions (if you are below the income limit). If you are above the income limit, however, you cannot deduct contributions to this account.
- Roth IRA – This is the Roth flavor of the IRA, meaning that your contributions are taxed, but once money is in the account, it grows tax-free. Withdrawals are not taxed assuming you are of retirement age. Only those below the income limit are eligible to contribute, but the backdoor Roth IRA workaround allows high-income earners to contribute despite their high income.
- HSA – Health Savings Account. This is the often-overlooked triple-threat of retirement savings available to individuals covered by high-deductible health insurance plans. Contributions are tax-deductible, earnings grow are tax-free, and withdrawals are not taxed, assuming funds are used for qualified medical expenses.
- Taxable Brokerage Accounts – These are non-tax-advantaged brokerage accounts available to everyone. While this type of account does not offer any tax advantages, they can be good places to park investable money over the allowable amount you can contribute to your retirement accounts.
- Savings Accounts – These are your run-of-the-mill risk-free non-tax-advantaged savings accounts that offer guaranteed interest on your savings. These types of accounts should typically used for emergency funds and savings for short-term specific goals (house, car, vacation, etc.).
Each type of account has implications for contributions, withdrawals, and income tax. Let’s summarize:
| Account Type | Annual Contribution Limit (2023) | Withdrawals | Tax Deductible Contributions | Tax-Free Growth | Eligibility Subject to Income Limits |
|---|---|---|---|---|---|
| 401(k) | $22,500 (Employee) $66,000 (Employee + Employer) | Withdrawals taxed as regular income; 10% penalty if under age 59.5 | Yes | No | No |
| Roth 401(k) | $22,500 (Employee) $66,000 (Employee + Employer) | Contributions can be withdrawn tax-free after 5 years; earnings can be withdrawn tax-free if age 59.5+ | No | Yes | No |
| Traditional IRA | $6,500 | Withdrawals count as regular income; 10% penalty if under age 59.5 | Yes, subject to income limits | No | Yes; cannot deduct contributions if over income limit |
| Roth IRA | $6,500 | Contributions can be withdrawn tax-free after 5 years; earnings can be withdrawn tax-free if age 59.5+ | No | Yes | Yes although can be bypassed with the Backdoor Roth workaround |
| HSA | $3,850 (Individual) $7,750 (Family) | Can only be used for qualified medical expenses; otherwise taxed as regular income w/ 20% penalty | Yes | Yes | No, but must be enrolled in a high-deductible health plan |
| Taxable Brokerage | None | No restrictions | No | No | No |
| Savings Account | None | No restrictions | No | No | No |
Whew! Don’t worry about remembering all of that right now, but refer back to this table if you get mixed up.
From Best to Good
All savings are good savings, but some account types offer more benefits than others when working towards our retirement goals. Given all of the rules around the accounts we outline above, our strategy should be to maximize savings into the “best” account types before moving on to the “good” account types.
Let’s take the example of our friend Thad, a 35-year-old single financially-savvy marketing executive. Thad is employed full-time as a W2 employee and has access to employee-sponsored retirement benefits. This year, Thad is stepping it up big time and aims to save 50% of this after-tax income. Here’s a quick overview of Thad’s income and savings:
| Annual Income | $200k |
| Annual after-tax income | $160k |
| Savings rate | 50% |
| Annual Savings | $80k |
Thad wants to maximize the future impact of every dollar saved. Here’s how Pete could prioritize his savings accordingly:
- Emergency Fund: It’s critical to have an emergency fund in case Thad loses his job. Thad wants to make sure he has enough saved up in a risk-free account to support his monthly budget for at least 6-months before he even thinks about investing elsewhere. Thad had to take out $1,000 to fix his car last year, so he wants to replace that money as soon as he can.
- 401(k) up to Full Employer Match: Thad’s employer will match 100% of his 401(k) contributions up to 5% of his salary, so Thad’s first goal should be to not miss out on this free $10,000 from his generous employer. This can be either a Roth or Traditional contribution, depending on his goals.
- HSA: If covered by a high-deductible health insurance plan, Thad should take advantage of this triple-tax-advantaged retirement account by maxing out his annual contribution limits. This will decrease his taxable income and allow his savings to grow tax-free, setting him up for success when he and/or his family has higher medical expenses or needs money for long-term care as they age.
- Roth IRA: Thad can contribute up to the annual maximum in his Roth IRA. Since Thad is over the income limit for tax-deductible IRA contributions, Thad can make a backdoor Roth IRA contribution to allow his money to grow tax-free.
- Remaining 401(k) Employee Contributions: Thad can contribute additional amounts to his 401(k) — Roth or Traditional — up to the annual individual maximum. While he won’t receive his employer match on this amount, the money will be grow in this tax-advantaged account until he needs it for retirement.
- 401(k) After-Tax (Mega Backdoor Roth): To truly super-charge his savings, Thad can take advantage of his employer’s after-tax 401(k) contributions and convert those contributions to Roth periodically. This will allow him to contribute beyond the annual individual maximum up to the much higher total combined employee + employer 401(k) limit.
- Taxable Brokerage: If he has any savings remaining, Thad can put them into this individual taxable brokerage account. While his earnings in this account are subject to double-taxation (tax on initial contributions and tax on capital gains/dividends) they will continue to grow over time. Thad can minimize his tax bill by investing in low-cost index funds and never selling them — i.e. “forever investing”.
To summarize, following this plan Thad would save the following amounts into his various retirement accounts. We are using 2023 numbers for maximum contribution amounts for each account type.
| Priority | Account Type | Total Savings | Notes |
|---|---|---|---|
| 1 | Emergency Fund | $1,000 | Replacing withdrawn funds |
| 2 | 401(k) Employer Match | $10,000 ($20,000 with match) | $10,000 contributions + $10,000 employer match |
| 3 | HSA | $3,850 | Individual yearly maximum |
| 4 | IRA | $6,500 | Individual yearly maximum |
| 5 | 401(k) Individual Max | $12,500 | $22,500 yearly employee contribution max – $10,000 in step 2 = $12,500 remaining |
| 6 | 401(k) After-Tax | $33,500 | $66,000 combined contribution max – $22,500 individual contribution – $10,000 employer contribution = $33,500 remaining |
| 7 | Taxable Brokerage | $12,650 | Everything else |
| Total | $80,000 ($90,000 with match) |
We can see that Thad was able to put most of his savings into tax-advantaged accounts, before depositing the remainder into his taxable brokerage account. Note that not all of these account types are available to everyone, so as we generalize this we will just skip over any options not available and move onto the next priority.
Some specific exceptions to note:
- If Thad is not covered by a high-deductible health insurance plan, he should skip priority 3 (HSA) and move on to IRA contributions.
- If Thad’s employer does not offer access to after-tax 401(k) contributions, he should skip that priority and instead start contributing to his taxable brokerage account.
Similarly, if Thad doesn’t have enough savings to max out each account type, he should plan to get as far down the list as he can. E.g. if he doesn’t have enough savings to max out his employee 401(k) contributions, he should put as much as he can in his 401(k) and ignore priorities 6 & 7.
Getting the Most Bang for Your Retirement Buck
By following a structured, prioritized retirement account contribution plan, we can ensure that we are minimizing our tax liability, allowing our savings to grow most effectively. Plus, it gives us tangible goals and milestones on our financial independence journey; Maxing out your 401(k) for the first time can be a satisfying and impressive milestone!
Rome wasn’t built in a day and very few people retired after one year of work. By leveraging our retirement account options consistently year-over-year we can build up tax-advantaged savings that enable a long and comfortable retirement.
