So you just landed your first job and want to start saving for your future or have been delaying retirement savings but are not sure where to start. There are choices to be made and we will break them down to better understand what path to take. The path can vary depending on your particular circumstance.
Employer Sponsored 401K Plan
If your employer offers a 401K plan that would be a logical first step and a majority of employers offer a match which equates to free money. You should at minimum contribute enough to get the full company match. A traditional contribution would be pre tax, all money going in would be tax free (deducted from your taxable income for that calendar year) and taxed during withdrawals at retirement or 55 year old. The plan could also offer a ROTH component, Roth contributions are funded with after tax money so no future tax is due. You can elect to contribute to either or split between the two up to $20,500 per calendar year and if you are over 50 you can contribute an additional $6,500. A third option and one that is not normally offered so talk to your plan administrator is an After Tax contribution.
The IRS puts a limit on how much can be contributed into a 401K, it currently sits at $61,000. This includes your money, and company match. For example if you max out your contribution of $20,500 and receive a company match of $3,500 that leaves you with $37,000 and can be added in After Tax contributions. This is usually utilized by high income earners and not for someone starting out, unless you’re jumping into a $200,000 a year job from the get go. A thing to remember is 401K have RMD’s (Required Minimum Distribution) at age 72.
Traditional IRA or Roth IRA
This would be your next option if a 401K is not available. Both traditional and Roth have a $6,000 yearly limit, which is adjusted every year or two for inflation. The Traditional contribution will lower your taxable income during the calendar year and any potential earnings grow tax-deferred, and are not taxed until you withdraw them after age 59½. The ROTH similar to the 401K is with after tax money and it grows tax free along with not having RMD’s.
The only caveat is there are income limits that phase out the availability, although at this time there is a loop hole called Back Door Roth. A Traditional Ira is funded with non deductible money (no tax break) and then rolled over into a Roth IRA. Best practice would be to this all at once to avoid having to pay tax on any gains while the money sits in the traditional. Be aware that in order to take advantage of the Back Door Roth you can not have an existing IRA. Also contributions have to be from earned income, if your 1099 or W2 is less than the $6,000 you would only be able to contribute up to that amount.
Next up is a standard brokerage account – Fidelity, Schwab to name a few. Today’s highly competitive market has just about every brokerage offering zero commission fees on trades. That’s great for any investor as every little bit counts and helps the portfolio grow. They offer just about every type of investment from mutual funds, ETF’s and individual stocks and great customer support.
TSP and 403B
These are reserved for government workers and non-profit organizations like hospitals and schools. They have similar limits to a 401K plan.
HSA – Health Savings Plan
Although technically it’s not considered an investment plan it is a great way to grow some tax free money. First requirement is to be enrolled in a High Deductible Health Plan, either thru your employer or ACA exchange. Contribution limits of $3,650 for single or $7,300 for families. Money is deposited in the account from your paycheck, some companies offer a “match” to help offset the High Deductible plan…once again free money and these contributions can be invested in mutual funds, ETF’s etc.
Typically an HSA is an account that you can withdraw from to pay for medical expenses and even over the counter medication. But savvy investor uses strictly as an investment vehicle. Why? Money going in is tax free, eligible withdrawals are tax free and growth is tax free. You can theoretically pour money into an HSA for 20 or 30 years let it grow TAX FREE, save your medical receipts along the way and reimburse yourself later on in life. After 65 there is no penalty for withdrawals but would still need to be for medical purposes to avoid the tax man, but as you get older the medical issues will grow and having the funds in an HSA will be a nice way to pay for them.
Which one is right for me?
If your just starting out and in a low tax bracket ROTH is the way to go, be it in a 401K or IRA. There is no point in the pre tax savings if you are already in the lowest tax bracket. As your career progresses and the income grows you can transition to pre tax contributions if you so choose. The Roth options is just to powerful to pass up.
Now if you are at the point where you earn enough to max out retirement accounts. This is how I would distribute the funds
- 401K – Fund up to the Company Match
- Roth IRA – Max out
- HSA – If it’s an option, take advantage.
- 401K – Once #2 is fully funded, turn back to your 401K and max it out.
- With $20,500 in a 401K, $6,000 in IRA and a maxed HSA if available. Anything extra can be placed into your after tax brokerage.
Most contributions are deducted from your paycheck on a weekly/bi-weekly basis it makes sense to sit down and do the math on what percentage goes where. If you know your going to max out the 401K and get paid biweekly $20,500/26 = $788 a pay period.
For your Roth IRA $6,000/12 Months = $500 a month. I prefer to save up during the year and lump sum the $6K at the beginning of the year into my ROTH IRA. In this article I compare lump sum vs monthly contributions and lump sum came out ahead every time.
The key is to start investing as early as possible, even small amounts.