Which Accounts Should You Use to Invest for Retirement? [Interactive]

An interactive guide to figuring out which accounts you should use, and how much to invest in each, for retirement.
Adam

Written by Adam on September 21, 2020.
19 min read. Calculators, Interactive, Investing, Personal Finance. 7 comments.

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When most people get started investing they’re bombarded with terms. 401(k), IRA, Roth, 457 – and those are just account types! It’s enough to scare many would-be investors away before they’ve even begun.

Today that will change! This interactive article shows which accounts YOU should focus YOUR time on learning about. To get started investing you don’t have to know everything – that’s what the experts are for. Instead, you just need to know which account (or accounts) are going to be most beneficial for your specific situation.

For most Americans, that means investing in your company 401(k). If you’re a high-earner, that could also mean putting a little money into a Roth IRA. If you’re a very high-earner, that could mean putting money into a brokerage account (an after-tax account). The vast majority of Americans will only need those three accounts for retirement (and maybe a Traditional IRA at some point, but we’ll get back to that).

Let’s solve this question for you once and for all. We’ll do that by determining exactly which accounts are best for you to invest for retirement. We’ll also figure out how much you should invest in each of these accounts.

Are you ready? Let’s get started.

There’s a lot to go over here. For starters, no form can cover every single case. Rather than using this as an ending point in your planning, think of it as a starting point. If you understand why each next account is the best choice for you, you’ll be well on your way to figuring out which accounts to invest in.

This visualization is based on a static graphic created by /u/BrainSturgeon on Reddit. It’s beautifully simple. Although the Reddit version is from 2014 and the contribution amounts have changed, the advice here is still valid for the vast majority of people saving for retirement.

With that in mind, let’s take these accounts one by one!

Emergency Fund (3-6 Months)

Adam says: Your emergency fund is cash in an easily accessible account – like a checking or savings account. Shoot for enough to prevent going into debt or withdrawing from investments if you lost your job and everyone in your house had a sudden health issue.

Even before paying off high-interest debt or maxing out the company match at your job, you should focus on creating an emergency fund.

An emergency fund is your first line of defense against everything bad that happens (and 2020 has proven just how bad things can get).

The purpose of an emergency fund is that you have enough cash on hand to cover anything that could likely go wrong – even if they all happened at the same time – without needing to dip into your 401(k) or ask for help.

Here’s my criteria for an emergency fund. Assume all of these things happened:

  • Everyone in your household loses their jobs.
  • Every pet has an emergency that requires a vet visit.
  • Every vehicle breaks down.
  • Your home is hit by a hurricane/wildfire/earthquake.

How much money would you need to have on hand to confidently continue living your life before things return to normal? For some people that might be 3 months of spending. For others it might be 6 months.

The more variables you have, the more reason there is to increase the size of your emergency fund. Own your house rather than rent? Increase your emergency fund. Have 3 kids? Increase your emergency fund. In a career where it would be difficult to find another job if you lost your current one. Increase your emergency fund.

The “liquid” part of an emergency fund just means that you should be able to easily access it without any penalties, taxes, or digging into a retirement account. It’s possible to use your Roth IRA in an emergency, but that should be an absolutely last resort and not part of your emergency fund.

If you’re the primary earner in a family, another way to think about an emergency fund is to ask yourself this question:

If I was hit by a bus tomorrow, would my family be OK?

While insurance might kick in and cover some things, an emergency fund would help bridge that gap and assure that they’re taken care of.

401(k) Up to the Company Match

Adam says: If you have a 401(k) with a company match, take advantage of it! It’s without a doubt the absolute best investment you can make.

401(k) accounts are the most commonly used type of investment account in the United States. These accounts are only offered by employers. With 401(k) accounts, you set aside some money from your paycheck before taxes that will go straight into the stock market in whatever mutual funds, ETFs, or other investments you choose.

Most companies also offer what’s called a “company match” on your 401(k). It’s usually phrased in a convoluted way:

We match 100% of your first 3% and 50% of your next 3%.

Another confusing 401(k) policy

What this means is that if your salary is $100,000, your company would offer a dollar for dollar match on your first $3,000 – 3%. The next 3% would get a 50% match which would mean you’d invest $3,000 and they’d chip in $1,500.

Adding those together: if you contributed 6% ($6,000), your company would deposit $4,500 into your 401(k).

In every single case I’ve looked at, this has been an amazing deal for any investor. If you went to Las Vegas and could put down $6,000 with a 100% chance you walk away with $10,500 would you? Of course! That’s the beauty of a 401(k) match.

The two main reasons why people don’t take advantage of their 401(k) match are that (1) they need the money or (2) they don’t understand how to invest. If you need the money for something else that may be unavoidable.

But if you don’t know how to invest that’s solvable! Learning how to invest in your 401(k) is a great first step to long-term financial literacy and independence. I have a 100% free course that goes over everything you need to know (which isn’t much). You can read it via email, or for free here on Minafi.

If you’re just getting started on your journey to invest for retirement, just opening up a 401(k) account with your employer (if they offer one) is a great first step.

High-Interest Debt

Adam says: pay off your credit cards and and other debt with interest rates above about 8%. At that point you’re paying more in interest than you would likely make in the stock market.

The term “high-interest debt” is a little ambiguous, so let’s break it down a little bit. What is and isn’t high-interest debt? Here’s a quick guideline.

High-Interest Debt Low-Interest Debt
Credit Cards Mortgage
Personal Loans Car Loans
Payday Loans Student Loans

Keep in mind that this is just a guideline. You can have mortgages that are high-interest and credit cards (especially in their first year) that are low-interest.

One thing that’s always helped me is to look at my statement and understand how much I’m paying in interest. Looking at your mortgage or student loan interest is eye-opening, but the interest rate may be low enough (<6%) that it makes financial sense to pay it off over time.

If you have a lot of high-interest debt – more than you could pay off in a year – consider consolidating it. This can dramatically lower your interest rate and allow you to pay it off much quicker.

One of the most common questions I hear is “Should I invest if I have debt?”. The answer is almost always yes! At the very least invest up to the match in your 401(k) first. If you don’t have a 401(k), I’d consider instead investing some amount in your Roth IRA. Partially because it’ll compound over time, but also because you’ll learn how to invest and get in the habit. Once your debt is paid off you can increase the amount you invest. You will have done the hard work now of learning how to invest.

Roth IRA

Adam says: Investing in a Roth IRA gives you options! You can take the money out tomorrow, or in 30 years. It’s an absolutely amazing type of account.

Roth IRA’s are my personal favorite type of investment account. You put money into a Roth IRA after-tax, invest it, watch it grow, then withdraw the money without paying taxes later. With 401(k)’s and IRAs, there’s a required minimum amount you need to withdraw in your 70s. With Roth IRAs, there’s no such requirement.

There is a downside to Roth IRA’s though: there’s an income limit. You must have an income of under this amount to fully fund your Roth IRA. If you make slightly over this amount you can fund your Roth IRA partially – which gets confusing fast.

Household Income Limit
Single < $124,000
Filing Jointly/Married < $196,000

So what do you do if you make more than the income limit? Well, you have 3 options:

Option 1: If you have no money in an IRA account, you can try a Backdoor Roth IRA. That allows you to contribute to a Roth IRA through a legal loophole.

Option 2: If you have a bunch of money in an IRA, you could try moving it to a 401(k) at your company. Once it’s moved over you can do a Backdoor Roth IRA without paying any taxes.

Option 3: If your income is above the limit and you can’t do a Backdoor Roth Conversion, then skip to the next account. Unfortunately, there’s no way to do it without paying taxes. If you get a 401(k) later and can roll your traditional IRA to it, then you could try a Backdoor Roth from that point forward.

One of the reasons I recommend a Roth IRA over a traditional IRA is for the flexibility of using a Backdoor Roth IRA later in your career. Let’s say you make less than the income limit ($124k) now but expect to be above it later. At that point, you wouldn’t be able to contribute to an IRA at all! If you had been contributing to a Roth all along (rather than a traditional IRA) then you’d be able to do a Backdoor Roth IRA Contribution.

Roth IRAs have one other amazing ability: you can withdraw your investment from them at any time without any early withdrawal penalty. This is huge! You can use this money for anything without conditions. The only thing you can’t withdraw without a penalty is the growth in those investments. Still, if you depot $50,000 in a Roth IRA you can withdraw $50k at any time with no fees or taxes.

When does it make sense to use a Traditional IRA over a Roth IRA?

The question of Traditional IRA vs Roth IRA comes up a lot. With both accounts, you have a $6,000 limit combined between them (as of 2020). This means the amount you put into your Roth IRA and your Traditional IRA needs to be $6,000 or less.

Contributions to Traditional IRAs are also tax-deductible if you meet certain requirements. You can also deduct your contribution if your employer doesn’t offer a 401(k), or if your income is below $65,000 (single) or $104,000 (married). You can see all of the limits on the IRS website.

So what’s better? Contributing $6,000 into a Roth IRA with after-tax funds, or contributing $6,000 pre-tax into an IRA?

It depends on taxes. If your tax rate-rate will increase in retirement (rare), then a Roth IRA is always better. If your taxes will go down then a Traditional IRA will be better. Most retirees see their taxes go down.

Why then do I recommend a Roth IRA over a traditional IRA? It all comes down to two things: options upon retirement and duration of deposit.

Once you retire, having a Roth IRA gives you an account to withdraw from that doesn’t raise or lower your AGI (adjustable gross income). You can use this to stay under a certain tax bracket or to lower your income for affordable care act reasons. Having this account as an option gives you that flexibility.

The second reason is duration of deposit. Let’s say that by the time you’re 28 years old you exceed the IRA tax deduction limit ($65,000 or $104,000). At that point, you switch to a Roth IRA and use that. At age 32 you exceed the Roth IRA limit of $124k/$196k. You still have another ~30 years you could invest for, but you can’t invest in a traditional IRA or a Roth IRA account. If you had invested in a Roth IRA from the start, then you could continue investing using a Backdoor Roth IRA for those 30 years. That’s $180,000+ in after-tax money you’re able to grow.

For the most part, the choice between Roth IRA/Traditional IRA isn’t going to make a huge difference in your retirement plan. At $6k/yr it’s much less than you’ll most likely save in your 401(k). I recommend you just put money into a Roth IRA and move on.

Related:

Health Savings Account (HSA)

Adam says: HSA’s are a super-account that can only be used for qualified medical expenses. There’s a limit of $3,550/$7,100 each year that you can deposit.

Health savings accounts are a special type of savings and investment account that is only usable on qualified health-related expenses. The Mad Fientist calls HSA’s The Ultimate Retirement Account, and with good reason! You get the tax-deduction of an IRA/401(k) and the after-tax growth of a Roth IRA.

You can even invest your HSA money in the stock market and see compound interest!

The only downside? You can only spend money from this account “qualified health related expenses”.

You may be wondering “why should I save that much for health-related expenses?” Well, the sad reality of the United States is that MOST of our health-related expenses are paid in the last few years of our lives. By saving a little bit each year, you spread this expense over a few decades.

You can also use an HSA to pay for your health insurance after you’re 65 years old, which is super-handy.

Once you’re 65 years old you can also withdraw money from your HSA just like a 401(k) or Traditional IRA! You’ll be taxed on the withdraws, but you won’t have to pay any other penalties. You can still spend money on qualified medical expenses without paying taxes on the withdrawals.

Side note: since I retired early about 2 years ago I’ve been paying for my own insurance – a bronze plan that costs $350/person per month with an HSA option. Every year I put away $3,550/$7,100 into an HSA now covers 1+ years of BETTER insurance later on in life when I’ll need it most.

Max Out Your Company 401(k)

Adam says: Have you heard the term “max out your 401(k)?”. That’s exactly what we’ll do in this step!

Remember how earlier on we only contributed up to the 401(k) company match? Now it’s time to fully max out that account!

For most people, this will mean depositing up to the $19,500 limit in your 401(k). If you’re 50 years old or older you can add another $6,000 each year on top of that.

There are other rare options that some 401(k)’s offer: after-tax contributions, in-service distributions, Roth 401(k). Exploring each of these would be another entire article. The important part is maxing it out first. After that, you could look into these other options.

There’s another edge case here too: if you have a lot of money in after-tax investments but can’t max out your 401(k). This could mean you had an inheritance, or you had a lot of savings at some point in the past. In that case, you could try withdrawing money from your after-tax accounts to live on and increase your 401(k) contribution to max it out. (side note: this is what I ended up doing in my 20s after I inherited some money).

After-Tax Investments

Adam says: You’ve done it! You’ve maxed out your tax-optimized accounts. All that’s left is regular old after-tax investing.

After you’ve taken advantage of all tax-advantaged investment accounts, your last option is investing money in a regular after-tax investment account. Also called a brokerage account, these are investment accounts you can open at any brokerage (I recommend Vanguard). You can transfer money into these accounts without any limits.

There is a downside to after-tax investment accounts. These accounts will most likely give off dividends that you’ll be required to pay taxes on each year. If you decide to reallocate your investments (by selling one fund and buying another) in this account you’ll be required to pay taxes on capitol gains. You’ll also pay taxes on these when you retire and sell them.

I love after-tax investments. They’re the key to our strategy to retire and pay $0 in taxes each year. By themselves they’re OK, but in combination with the other accounts above, they do even better. Don’t think about money in these accounts as a failure to find a tax-optimized account for them! Instead, think of them as a super-flexible account that will be a superpower later.

What About X and Y?

This guide doesn’t cover every single case – that’s for sure. There are a few that I did want to call out though.

If you have a high-interest mortgage or car loan, consider refinancing. Mortgage rates are at all-time lows right now.

You may want to consider paying off your mortgage, a car loan, or some other low-interest debt at some point. I’d bucket this in with the “after-tax investments” bucket. If you’re able to save a bunch at that stage, you might want to consider switching from a 30-year mortgage to a 15-year mortgage to take full advantage of this. Even putting another $100 a month into a mortgage may cut years off your mortgage.

If you have kids, try saving for college using a 529 plan. This would come in somewhere after “high-interest debt”. Depending on how much time you have to save, you could put this below Roth IRA or above it.

There are other types of retirement accounts – 457, 403(b), SEP IRA’s, and more. Some lucky government and non-profit employees have access to both a 401(k) and one of these accounts, enabling them to max out two accounts! If that’s you, consider yourself lucky! Just copy/paste the 401(k) account for any additional accounts you have.

Some 401(k) accounts allow for Roth 401(k) contributions. The primary reason to invest in this type of account is if you believe your taxes are going to be HIGHER after you retire than they are today. You may also consider this type of account if you want to take the tax-hit today for the extra flexibility later.

A very select few 401(k) accounts allow for after-tax contributions up to $50,000+. Here’s how it works: after you max out your 401(k), you can then put in another ~$37k into your 401(k) in an “after-tax” bucket. You can roll this amount over to a Roth IRA – blowing the usual $6k/yr limit out of the water. You 401(k) has to allow after-tax contributions and in-service distributions, but with those two options, you can perform a Mega Backdoor Roth Contribution.

There are even more accounts I haven’t mentioned. If you have a question about one, feel free to ask in the comments! I’ll continue updating this post with more situations as people mention them.

Adam

About Adam

Hi, I'm Adam! I help millennials invest to reach financial independence sooner than they ever thought possible. Want to see what you could do to reach FI sooner? You're in the right place!

7 Comments

Why not add to the conversation below? Your voice is welcome!

I love your interactive pages! I think all of this is great, but I wish you put in a small caveat about insurance plans. I think people need to pay for life and disability insurance, (in most instances), before investing. I know that isn’t the purpose of this post, but I think it’s an important piece of financial advice that often gets overlooked.

Insurance is a tricky one. To be honest I’m not an expert in that case. For most of our careers my wife and I had some form of life insurance from our employers that may cover $100k or so in the event of our deaths, but nothing for disability.

Where would see those two in the stack of accounts? And for how much insurance?

It seems for the 401k match, you’re subtracting $19,500 from the match to include the 401k match from the employer. But, the general limit on total employer and employee contributions for 2020 is $57,000.

Hmm, I think it’s something else actually – which means I’m visualizing it clearly enough.

The 401(k) match + 401(k) sections should equal $19,500 (or $26k if you’re 50+). This doesn’t take into account, or even show how much the company is matching. I considered it, but because so many matches have multiple points (ex: match 100% of first 3%, then 50% of next 3%) I decided not to show or compute how much the company match equals in real dollars.

That does mean that there’s a chance that the full amount of someone’s 401(k) contribution + company contribution could exceed the $57k limit. I should change up the “401(k) match” maximum by an employee to be $19,500/$26k to make that more fool-proof for very large incomes (thanks for the heads up!). If someone’s company matches more than 300% of 100% of their contributions then this would exceed the max, but I think that’s an edge case.

I love these interactive pages so much thank you for using your expertise to creates these for us. Would it be hard to add SIMPLE IRA or SEP IRA accounts? I have a lot of self-employed people and small business owners in my community that I think would benefit from more info on these accounts.

I’m open to adding this! I’m interested to add some of the next most used accounts, and I have a feeling those would be up there on the list.

I like your interactive blog. Talking about the accounts to invest for retirement, I would like if you can actually use cryptocurrency investment to explain further in another post or something