Which Accounts Should I Use? How to Choose Between Roth IRA, 401k and Others — Start Investing Series
This is the second post in a series on How To Be Brave & Start Investing.
In the first post in this series, I asked “Why are you investing?”. Today we’ll use that information to understand which type of account you should put your money in.
The Account Type Playing Field
Let’s start with an overview of the three main types of accounts. These are the major account types. If you understand these 4 account types, chances are that’s all you’ll need to ever use for personal investing. There are other account types out there, but I’d argue that in almost all cases one of these 4 would be more beneficial. There’s a few key points to know about each of these accounts you’ll want to watch for:
- When can I add money? Pre-tax or after-tax?
- When can I remove money? What are the penalties for early withdraw?
- What are the limits of how much I can contribute?
- Where do the funds come that go into the account?
Traditional 401k Account (pre-tax)
These are the most used investment account in the USA. Unfortunately, you cannot open a 401k on your own, you must have one provided by your employer. If you are self employed, you can also start one up for your business. 401k accounts have the bonus of lowering your earned income, reducing your taxes, while allowing you to contribute a net higher amount.
- How to Open: If your employer offers this, you can work with them to create it.
- Can be used by: Anyone in the USA with an employer who offers a 401k account.
- When to use: Pre-tax. Your employer will add money directly to this account if you choose to do so.
- Best for: Reducing taxes. Getting a free “company match”. Best to use Use a 401k when you’re expecting to be in a lower tax bracket when you extract funds than you
- Limitations: (for 2017) $18,000/yr for those under 54 years old and $24,000/yr for 54+.
- Can use: At age 59½ or if owner becomes disabled. Must have started using by age 70½.
- Worst for: Using when you need to withdraw before age 59½.
- Tax Implications: You’ll pay less payroll taxes when you add money (maybe getting money back after doing taxes). Instead, you’ll pay taxes when you withdrawal money from this account.
Roth IRA (after-tax)
Roth’s are the most versatile type of investment account there is. These accounts can be opened by anyone in the USA at a number of financial institutes. I recommend vanguard.com for opening this up — even if you have investments elsewhere — I think everyone should eventually move their funds to Vanguard.
- How to Open: My recommendation: save up $3,000, head to vanguard.com and create an account.
- Can be used by: Anyone in the USA with an income they file taxes on.
- When to use: Post-tax. You generally transfer money from your bank account into a Roth-IRA — either all at once or throughout the year.
- Best for: Taking advantage of the sweet sweet tax benefits. When you want to grow money and not pay taxes on it.
- Limitations: (for 2017) $5,500/yr for those under 49 years old and $6,500/yr for 50+. This limit applies to Roth IRA + Traditional IRA (below). You cannot contribute more than you earned. Your modified AGI (adjusted gross income) should be less than $118,000 to use a Roth (technically you can use them up to $133k, but it gets weird — just assume if you make less than $118k, you can use a Roth IRA).
- Can use: At age 59½ or if owner becomes disabled.
- Worst for: Converting a 401k/Traditional IRA into when you’re in a high tax bracket.
- Tax Implications: You pay taxes on money you’ve earned from working, then add to a Roth IRA. When you withdrawal money from the Roth at age 59½, you can pay $0 in taxes.
Traditional IRA Account (pre-tax, or after-tax)
Traditional IRA accounts are weird. They serve 3 completely separate purposes, making it more difficult to give an abbreviated description.
- How to Open: My recommendation is that you shouldn’t — unless you need to do a Backdoor Roth IRA Contribution.
- Can be used by: Anyone in the USA with an income they file taxes on.
- When to use: 3 ways — 1) When you leave a job you may have the option to transfer a 401k to a tIRA (I’ll likely write a post on why should almost never do this). 2) Add after-tax earned money to an IRA, then deduct that on your taxes. 3) Add after money to an IRA, but don’t deduct (backdoor IRA method).
- Best for: Backdoor Roth IRA contribution.
- Limitations: (for 2017) $5,500/yr for those under 49 years old and $6,500/yr for 50+. This limit applies to Roth IRA + Traditional IRA (above). You cannot contribute more than you earned. Your modified AGI (adjusted gross income) should be less than $118,000 to use a Roth (technically you can use them up to $133k, but it gets weird — just assume if you make less than $118k, you can use a Roth IRA).
- Can use: At age 59½ or if owner becomes disabled. Must have started using by age 70½.
- Worst for: Converting a 401k/Traditional IRA into when you’re in a high tax bracket.
- Tax Implications: When you withdrawal funds, you’ll pay taxes based on how much of the funds are considered “pre-tax” and on how much the funds have grown.
Brokerage Account (after-tax)
A brokerage account is kind of like a general checking or savings account, but instead of having money in a bank, held in cash, you have money in a brokerage held in stocks (and other financial instruments).
- How to Open: There’s a bunch of brokerages you’ve likely seen ads for (E-trade, Scottrade, etc). If you have over $500k at Vanugard account your trade cost is $2, and that’s a great option. Otherwise, Robinhood is a great place to trade for free. I’ve also liked Tradeking (now Ally).
- Can be used by: Anyone in the USA with some cash to transfer over.
- When to use: When you have money after the above contributions.
- Best for: Money you can liquidate and have in cash at anytime. The only place left after exhausting tax-sheltered accounts.
- Limitations: You’ll need to think a lot about taxes. Whenever you sell funds in a brokerage account, that’s a taxable event and it could have massive ramifications come tax-time.
- Can use: Anyone!
- Worst for: Trading often, since you’ll pay commissions and taxes at a higher rate.
- Tax Implications: Imagine a ledger of all gains/losses for sales from this account within the year. Now add any gains in dividends you made during the year. If that number is positive, you’ll pay taxes. If it’s negative, you’ll get a tax deduction for your investment loss.
OK, But Which Should I Use?
That’s a lot, I know. Take a look at this amazing graphic to get a handle on how to use the above account types, along with other things going on in your personal finance journey.
This chart is amazing. I love it so much. It communicates just about everything I’d want in an infographic on where to put your funds. There’s a few areas that are rough around the edges:
- Debt — “Payoff high interest loans” is ambiguous. I’d define this as loans under 6% that aren’t tax deductible. A mortgage, for example, I wouldn’t recommend paying off first, but you could pay it down bit by bit.
- Saving for large purchases (ex: home purchase) — I’d put this category in the same area as “Company 401k Up to $18,000” section.
- If I have debt, should I buy a house? If you can save 20% down payment on a house, then why aren’t you paying off your debt? I’m very anti-debt, so that would be my advice. One large loan at a time.
Scenerio 1: Making $50k/yr with some debt
We’ll follow the life of Tom, a completely made up normal guy who graduated college, took on some debt and wants to start saving. Any similarities to people named Tom are coincidental. I’m also combining some pretax/post-tax numbers for savings to simplify calculations. Here’s his potential journey over the next 15 years.
Persona: Tom (age 25)
Income: $50k/yr
Debt: $8k in credit card debt (11%), $30k in student loan debt (4.5%)
Savings: $2,000 in checking.
Cashflow: ~$3,400/mo paycheck
Savings Rate: 8% (spending $3,100, saving $300).
Looking at this scenario, there’s a few clear steps to take:
- Months 0–31: Build Emergency Fund: At $300/mo, they’ll Tom will need to save up for 31 months to have an emergency fund. Alternatively, he could find more expenses to cut in order to lower that timeframe.
- Months 32+: Start maxing out 401k company match. Also start paying off that 8k in debt.
- After debt is paid: Tom is making less than $118k/yr, so he can start trying to max out his Roth IRA.
- After maxing out Roth IRA: Start contributing more on the 401k. He likely won’t be able to max it out unless he drastically cuts his spending.
What about the student debt? That’s up to everyone to understand how much that weighs on them, but I’d leave it — or perhaps pay a notable amount over the minimum to pay it off faster while still putting a lot into savings. The student loan interest is tax deductible, which can offset some of the interest.
It’s not sexy, but if tom can save $300/mo, then by age 27, he’ll be credit card debt free and able to put a lot more in savings. The major things he should be focusing on are:
- Filling an emergency fund
- Contributed to his 401k to get a company match
- Payoff his credit card
It may sound odd to contribute to an emergency fund when Tom has $8k in high interest debt. I’d look at it a different way though — why does Tom have $8k in high interest debt? I’m guessing it’s because he didn’t have an emergency fund and decided to make a purchase. By prioritizing the emergency fund, we’re preventing that $8k from growing by having something to lean back on.
Scenerio 2: Making $75k/yr
Tom has stuck with it! He’s now making a higher salary, has some savings, and has avoided the lifestyle inflation trap. Because of this, he’s able to save MUCH more each month.
Persona: Tom (age 30)
Income: $75k/yr
Debt: $20k in student loan debt (4.5%)
Savings: $10,000 in checking, a growing amount in a 401k and some in a Roth.
Cashflow: ~$4,800/mo paycheck
Savings Rate: 35% (spending $3,100, saving $1,700) for $20k/yr savings
At this point, just about every month is the same. He doesn’t need to worry about savings or debt reduction and can focus a lot more money on savings. Here’s a plan for Tom (30):
- 401k Up until the company match (ex: 6% of 75k = $4500/yr).
- Roth IRA — $5,500
- 401k — Contribute another $10k (or more if possible).
All of the sudden, Toms able to contribute much more to savings, and even pay down his student loan more. He’s also in an interesting situation where he could payoff his entire student loan in a single year — but should he? I’d argue no, he shouldn’t. Instead he should take advantage of the free money from his company 401k, and from the free tax benefits that come with a Roth at the very least.
The remaining 10k going into his 401k could start being split with his student loan to pay it off in a few years.
Scenerio 3: Making $120k/yr
Tom’s career has gone up up up! He’s paid off all his debts, and his salary has consistently climbed (we won’t talk about how much he job hopped). In a period of just 5 years by not spending more, Tom grew to saving a LOT and he’s now saving more than half his income.
Persona: Tom (age 35)
Income: $100k/yr
Debt: $0
Savings: $10,000 in checking, a over 401k and some in a Roth.
Cashflow: ~$7,400/mo paycheck
Savings Rate: 55% (spending $3,300, saving $4,100) for $49k/yr savings
At this point, just about every month is the same. He doesn’t need to worry about savings or debt reduction and can focus a lot more money on savings. Here’s a plan for Tom (30):
- $4,500 — 401k up until the company match (ex: 6% of 75k = $4500/yr).
- $5,500 — Tom is making too much for a Roth IRA now. Instead, he’ll need to contribute $5,500 to a traditional IRA. If he moved that money into a Roth IRA (at no tax implication) that would be a Back Door Roth IRA.
- $13,500 — Max out that 401k
- $25,500 — This could be put into savings, a brokerage, towards a house, a car — whatever.
After this point the money you’re putting aside could be put into a ton of different investments. Aside from stocks and bonds (which we’ll talk about in the next article), you could try real estate, or invest in businesses.
Three Stages of Investment Account Usage
This is the end of our time following Tom’s journey. In these 3 examples we went through 3 major stages:
- Debt Reduction Phase— focus on developing an emergency fund, 401k company match, paying debts. (Used: 401k)
- Tax-Deferred Maximizing Phase — trying to fill up all tax incentivized accounts to their fullest. (used: 401k, Roth IRA)
- Hyper-Growth Phase— all tax incentivized accounts are maxed out and you’re still putting more money aside. (401k, Traditional IRA -> Roth IRA, Brokerage)
Depending on where you are in your investing journey, that’ll indicate which of these accounts you’ll get the most out of. The less debt you take on, the lower your spending and the higher your savings rate, the faster you will transition through these phases to the hyper-growth phase.
Which Account Types Do You Use?
Of these 4 accounts, which ones are you using — and why? Are you paying off your debts in the same order as the visualization? What could you be doing to move to the hyper-growth phase faster?
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