A friend of mine recently sent me a text, which is the inspiration for this post:
Hey Tom, looking to start some kind of investment account for our baby. Was thinking of just starting a joint account with his name and my name and throwing money to some index funds versus the alternatives of savings plans/etc where the money could go. What say you?
Great question, Shawn. While the question is specifically asking about using a taxable investment account vs. something like a 529 or a prepaid college savings plan, let’s take a step back and first look at all of the possible locations for putting savings. It’s helpful to look at them in three different buckets:
Pre-Tax Savings Buckets: I’m calling these “pre-tax” because contributions to any of these buckets are done BEFORE you pay federal income and state income taxes (and for the HSA, before you pay social security and medicaire taxes), meaning you don’t pay taxes on contributions. Another way to look at contributions to these buckets is that they reduce your taxable income in the year when you make the contribution. These buckets all have restrictions and penalties on withdrawing money that are designed to encourage you to use them for “retirement.” More on this later.
- 401K: up to $18,000 for an individual in 2017
- Traditional (deductible) IRA: up to $5,500 for an individual in 2017
- Health Savings Account (requires a High Deductible Health Plan): $3,400 individual, $6,750 family
Tax-Advantaged Savings Buckets: While these buckets also provide tax advantages, they are not “pre-tax” (529 is often pre-tax for state income taxes if you invest in your state’s plan, but not pre-tax for the more significant federal income taxes). These buckets have similar restrictions as the pre-tax buckets.
- Roth 401k: same limits as 401k
- Roth IRA: Up to 5,500 for an individual in 2017. Earnings grow tax free, withdrawals of earnings after age 59.5 are also tax-free
- 529 Plan: (details vary by state)
Taxable Savings Buckets: These buckets provide no tax advantages when contributing or withdrawing the money. They are also the most flexible because they don’t have the same restrictions and penalties as the pre-tax and tax-advantaged buckets.
- Taxable investment account
- Bank account (savings, CD’s, etc.)
- Lots of other stuff (e.g. peer to peer lending)
Each one of these buckets has advantages and disadvantages, but the key thing to understand how to prioritize the buckets is the concept of the fungibility of money. This is a concept that’s easier for me to explain using examples I’ve heard in real life than to give you a crisp definition. Here’s a common reason I hear from friends as to why they don’t want to max out their pre-tax buckets:
I don’t want to max out my retirement accounts because I don’t want the money locked up until I’m 59.5. I want access to my money before that.
This logic makes sense only in a couple of (rare) circumstances:
- You have some immediate needs for the money (e.g., saving up for a house down payment)
- You plan to save $0 for your life when you are 59.5 or older
If those circumstances don’t apply, you will get the biggest benefit by funneling your extra money (savings) to the bucket that provides you the highest value each year. If you are ever planning to retire, by far the biggest value bucket is the first one – the pre-tax savings. And because it provides the most value, you should not go after the other buckets until you have maxed out all of your pre-tax space. Since you’re going to need money in that bucket, put the money in now where you get the biggest tax benefit from doing so.
Prioritizing the buckets
So hopefully I’ve convinced you that each bucket has value and you should max out the most valuable buckets before contributing to buckets with lower value. If you’re convinced, the next question is how to prioritize the buckets. Here’s how I see it:
1. 401k up to company match: If your company offers a 401k, they probably also offer matching contributions. These vary by company, but if you have one you should do anything you can to get this match. If you don’t know if your company offers a match, stop reading this article right now and find out. This is free money. For example, my company matches 4% if I contribute 5%. So if I contribute $5,000 in a year, they will give me $4,000. That’s an instant 80% ROI. You will not get that kind of return anywhere else.
Total savings required: Varied depending on how much you have to contribute to get your full company match. We’ll asssume $5,000.
2. HSA: This may be a surprise entry, but the HSA used properly is the most flexible retirement account. Payroll contributions are not subject to social security tax, medicaire tax, federal income tax or state income tax. You can withdraw the money at any time as long as you have qualified medical expenses. And even if you don’t have enough medical expenses, it turns into a Traditional IRA when you turn 65. The Mad Fientist has an excellent article about the HSA here.
Keep in mind that you have to have a High Deductible Health Plan (HDHPs) in order to qualify for the HSA bucket. I’m a big fan of HDHP’s, despite having some major unexpected medical expenses over the past few years. Stay tuned for a future post on the benefits of HDHPs over traditional health plans.
Total savings required: $3,450 individual / $6,750 family. We’ll assume family, so another $6,750, bringing our running total up to $11,750.
3. Deductible Traditional IRA: The rules here are a bit complicated, but if you qualify to make deductible contributions to an IRA, this is the next bucket to max out. Depending on your adjusted gross income and whether you have a retirement plan offered at your work, this can add up to $5,500 of pre-tax space for individuals and up to $11,000 for married couples.
One of the neat tricks to investigate for yourself here is the spousal IRA. If you are married and one spouse does not earn income, you can still contribute to that person’s IRA with the money from the person who does work, and depending on your household income you can get a deduction just like you would with a deductible traditional IRA. I actually didn’t realize this was possible for our family until recently – it’s a neat way to get another $5,500 of pre-tax savings space.
Total savings required: We’ll assume $5,500, bringing our total up to $17,250.
4. 401k up to $18,000: After you’ve put in enough money to max out your 401k, and then enough to max out your HSA, the next best bucket for your money is the amount you have left to max out your 401k ($18,000 for an individual in 2017).
Total savings required: Since in this example we already contributed $5,000, we have $13,000 of space left. This brings our running total up to $30,250.
At this point, we’ve reached a huge milestone – maxing out ALL available pre-tax space, which will make a huge dent in the amount of taxes paid, and boost most people’s savings rates well into the double digits.
5. Toss up: Taxable investments, paying down mortgage if applicable, Roth IRA. I used to be a much bigger believer in the Roth IRA, but there are some great resources online (GoCurryCracker and Financial Samurai both have great explanations) that show how taxable accounts are comparable to Roth IRAs and much more flexible.
The other “bucket” here is considering paying down your mortgage early. There are an endless number of articles debating whether its better to pay down a mortgage or invest, and that decision is going to come down to your own risk tolerance and feelings about debt. I’m working on an article outlining my own hybrid strategy which I will link to here.
6. 529: So we finally get to the answer to my friend’s question above. The 529 ranks way down on my list of buckets for a bunch of reasons. First, it does not provide any deduction for federal taxes. Second, it is more restrictive than all of the options above. It has to be used for qualified education expenses.
Never: Roth 401k. There are some rare examples where a Roth 401k makes sense, but for most people the goal should be to pay as little taxes as possible each year. There are so many creative ways to craft income to reduce or eliminate taxes in retirement that it almost always makes sense to minimize taxes during earning years. If you are positive that you will realize more income in retirement than in your working years, a Roth 401k makes sense. But this is just not going to be the case for the vast majority of people because it usually requires either saving insane amounts of money or getting a huge inheritance in retirement.
Pre-Tax Savings Bucket Example
So what maxing out pre-tax space look like? Let’s look at an example. We’ll consider two families with the following stats:
- Both have two earners and a combined income of $125,000.
- Both have two children.
The first family is going to max out all of their pre-tax space. We’ll call them the Pre-Tax Prodigies. The second family is not going to put any money into that space. They are affectionately named 59.5 Is Too Far Away. Check out the results.
The first, most obvious difference is that the Pre-Tax Prodigies paid 57% of what 59.5 Is Too Far Away paid federal income taxes than ($9,875 vs. $17,239). Our pre-tax family had an effective tax rate of 7.9% and ended up in the 15% marginal tax bracket, while the other family had an effective tax rate of 13.8% and was well into the 25% bracket. Pre-Tax Prodigies also got an additional boost by getting the full $2,000 of the child tax credit, while the 59.5 Is Too Far Away only received $1,250 because their adjusted gross income was above $110,000.
But look at where both families end up from a savings perspective. The Pre-Tax Prodigies saved $34,250, or 27% of their total income, and they still have $84,875 left. Remember, they got $4,000 for free from their company 401k match, and they paid a lot less in taxes. ~$29,000 of that money came out of their payroll deductions, so it was money they never actually saw or had the chance to spend. Also, that $34,250 will continue to grow tax-free until retirement.
Meanwhile, 59.5 Is Too Far Away didn’t save anything in pre-tax accounts. If they wanted to put $34,250 in savings, they would end up with $73,510 left, which is explained by missing the 401k match and paying $7,364 more in taxes. Because none of the money came out of payroll deductions, they would first have to be disciplined enough not to spend the money, then they would have to move it to taxable accounts where the money is also easier to spend. This money would not grow tax free – every year earnings would be subject to taxes. They needlessly gave $7,364.50 to the federal government and missed out on $4,000 of free money from their employer.
The Bottom Line
There are huge advantages to maxing out all pre-tax buckets. For families that want to accelerate their savings and achieve financial independence sooner, these buckets can be game-changers.
Also, because money is fungible, you should always prioritize filling your more valuable money buckets first. Going back to the question about funding college, my position is that funding that bucket does not make sense until you’ve maxed out all pre-tax buckets AND paid off your home mortgage. Here are a couple of reasons why – more details to come in a post devoted to hacking college expenses:
- The financial aid application (FAFSA) does not count home equity or retirement accounts in its aid calculations. It DOES count 529 accounts.
- Since money is fungible and pre-tax accounts are more valuable, maxing them out every year is going to come out ahead of NOT maxing them out to fund a 529.
Think of it this way – if you are saving $30,000/year in pre-tax accounts from the day your college-bound child is born, and getting a 7% real return on your investments, you will have $1.1 million dollars in retirement accounts by the time your kid goes to college 18 years later. NONE of this will be reportable on the FAFSA, meaning you’ll get more financial aid.
At this point you can stop saving in pre-tax accounts and divert that $30,000 to college expenses, which will be lower because you’ll qualify for more aid than someone with a hefty 529 balance. Your $1.1 million will continue to grow tax-free while you are not adding contributions. Additionally, if you end up needing some of that $1.1 million dollars, there are creative ways to get it without a penalty, and even if you have to withdraw the money early and pay the 10% penalty, you usually will still come out ahead vs. not using the tax-advantaged space in the first place! The Mad Fientist has the best explanation of these points – check out his excellent article here. Another great blogger, Joel from FI180, also shared his own numbers and how they plan to withdraw from retirement accounts in early retirement here.
This turned out to be quite a long post. If you stayed with me this long, I’d love to hear your feedback in the comments!