[Editor's Note: Today's post from The Physician Philosopher is about determining the best order to fill up your investing accounts. I'm not sure I entirely agree with his recommended order (we max out HSAs and Roth IRAs first each year), but ideally, you can max out all of these and still invest a bit in taxable. If you weren't able to max them all out, I would max out the tax-deferred accounts first during peak earnings years. Take a look and see what you think about TPP's recommended order. ]
You may notice the main image for today's post. It is a free-flowing waterfall. Look at how the water completely covers the first set of steps at the top, before it spills over to cover the next step. And the next step. Until finally it reaches the bottom. The correct order to fill up our retirement accounts each year should follow a similar pattern. We should fill up one retirement account until it is full and then move on to the next. And then the next until we have reached our annual savings goal. This is the order of investing, sometimes referred to as Waterfall Investing.
This post is meant to help you determine the order in which you should fill up your investment accounts. Before we can do that, though, you need to go back and first determine how much money you need to be saving each year. If you do not know your annual savings goal, then click here to read a post on determining how much money to save each year.
Waterfall Investing Basics
The order in which you should fill your retirement accounts until you get to your annual savings number should have a method to it. Typically, I prefer to fill up tax-advantaged space first that is most readily accessible and then move towards the less tax-advantaged space with each step.
One caveat to this is that if you are planning to FIRE (Financial Independence Retire Early) well before the age of 59.5, then you won't be able to easily access many of your tax-advantaged retirement accounts. While there are ways around the early retirement gap, it might change how you invest your money.
For example, you might prefer to put a higher proportion of your money into a 457 or a taxable/brokerage account. Both of these can be accessed in early retirement and/or when you separate from your employer. A 401K or 403B will likely be placed into a rollover IRA after you leave your employer and will be hit with the 10% penalty if taken out before age 59 and a half.
The Traditional Order
Everyone has access to different plans. For this reason, I've tried to include everything that a typical doctor has access to for retirement. If something is left off of this list, leave it in the comments and I'll put it into the list.
Four quick comments before we get to the list:
First, all of the information below ignores your debt. Readers will know that I am an avid-believer in paying off debt. [You can read here about how I paid off $200,000 in student loans in 19 months]. In fact, I've previously chosen to pay off debt over maxing out my Backdoor Roth IRA for the year. If you have credit card debt or other high-interest debt, please consider paying that off immediately after Step 1 (get the 401K match).
Second, the order in which this list operates is from most tax-advantaged to least tax-advantaged. The assumption being that most people reading this post will be in their peak earning years during the accumulation phase. As you approach retirement (the distribution phase) your investment choices may look different.
Third, if you are married, you should duplicate each step if your spouse has access to the same type of account. For example, you should max out both of your 401K's before proceeding to the next step.
Fourth, the maximum contributions to retirement plans below do not include “catch up” contributions. Individuals who are over the age of 50 can contribute more money (usually $6,000 more for 401K/403B/457 plans).
The Order Of Investing for Retirement: Waterfall Investing
Here are the first several steps in your Waterfall Investing Plan. You'll note that all of the ones listed below offer a tax advantage.
To some extent – depending on your retirement plans – the order of these accounts may be flip-flopped a bit.
1. The 401K or 403B
A 401K or 403B (hereafter referred to as “401K” to make it easier to read) is the first place your money typically should go. The reason is that employer's often offer a match. Any money not placed into this vehicle (up to the match) is money lost that could have been invested. This is the reason I think you should invest at least to the match, even if you are swimming in student loan debt.
Some plans have the choice to invest pre-tax or Roth. In your peak earnings years, it is traditionally recommended to take advantage of the pre-tax offering in order to decrease your tax burden.
The maximum that can be placed by the employee into a 401K is $19,000 [$19,500 in 2020/21]. It can receive matching or contribution money from the employer up to $56,000. Once you have placed your annual maximum into your 401K/403B, it is time to move onto the next step with our flow of money.
Note: If you have credit card debt or all-consuming student loan debt… you should probably work on paying that off before proceeding to the next steps.
2. Governmental 457 Plans
The second step in waterfall investing involves putting money into a governmental 457 plan. I would argue that you should prefer to place your money into a governmental 457 before your 401K/403B if the 401K does not offer a match. The reason for this is that 457 money can be utilized when you retire regardless of your age.
Note this is a governmental 457 plan we are talking about. Not a non-governmental 457 plan. Read this post on 457's if you don't know the difference.
The maximum that you can place into a 457 plan is also $19,000 [$19,500 in 2020/21]. And, yes, you can max out both your 401K and your 457. That's not a problem.
3. Max Out Your Health Savings Account (HSA)
The HSA plan is the only triple-tax free plan that exists (some call it the Stealth IRA). You place pre-tax money into the account. It grows tax-free. And, so long as it is used for medical expenses, it never gets taxed when pulled out.
Honestly, it is the best investment plan that exists so long as it offers low-cost index funds. However, you shouldn't choose an HSA plan just for the retirement benefits, if the actual insurance plan offered through it doesn't best suit your family's need.
If the HSA does work well for you and your family, you can shelter up to $7,000 for families ($3,500 for individuals) [$7,100/$3,550 for 2020/21]. And, it may never get taxed again!
4. Cash Balance Plans
Some practices offer cash balance plans, which are another way to shelter pre-tax money. I will not pretend to be an expert on this kind of plan. They can get complicated, and the rules are different for every partner depending on age.
From what I understand, most plans do not last a long time, and it is more advantageous to have one when you are older in your career than younger.
The amount of money you can place into this kind of account depends on age. Word on the street is that, for most doctors, $10,000 to $100,000 can be placed into this account (pre-tax) annually.
Of course, make sure the plan is right for you. If your administrator is investing in high expense ratio actively managed funds, you should probably put your money elsewhere.
5. Backdoor Roth IRA
If you still haven't reached your annual savings number (or don't have some of the accounts listed above available to you), then the backdoor Roth IRA is the next step.
This is sheltered differently than the accounts listed above. This account offers post-tax benefits. The money contributed has already been taxed. However, unlike a regular taxable/brokerage account, the contribution and the capital gains will not be taxed again.
This is often the last account you'll touch in retirement. Roth money is also the best way to give money to your heirs because of the Stretch Roth IRA. [Note that IRAs can now only be stretched for 10 years.-ed]
6. Non-Governmental 457 Plans
Non-governmental 457 plans (NG 457s) are not as straight forward as governmental plans. I've dedicated a whole post to this topic, and I've linked to it above in this post.
The reason it is so much lower on this list is that it is not really “your” money. It is your employer's until you get paid the money back after you separate employment or retire.
However, it is investment money that is contributed pre-tax. It will decrease your overall tax burden. And, so, if you have a good NG-457 plan then you should probably invest in this account before you start doing things that are not tax-advantaged.
This account has a max of $19,000 [$19,500 2020/21] annual contribution.
7. Taxable Accounts
This is the big pool at the bottom of the investment savings ladder. Once you have filled up all of the space available to you mentioned above, then the rest of your money goes in here until you reach or exceed your annual savings goals.
These accounts can be opened at any of the major investment companies (vanguard, fidelity, Charles Schwab, etc).
A Case Study Example
Say, that you have determined that you want to be saving $125,000 each year. What do you have available to you? Well, if you max out your 401K your employer will contribute/match up to $45,000. You also have an HSA and NG-457 plan available. Your spouse works, and he has access to a governmental 457.
For the sake of the example below, let's assume that the NG-457 plan is a good plan worth investing in for retirement.
So, following the order above we would do the following:
- Contribute $19,000 to 401K + match/contribution from employer = $45,000
- Max out governmental 457 = $19,000
- Contribute max to HSA for family = $7,000
- For each spouse, max out backdoor Roth IRA money = $6,000 x 2 = $12,000
- Max out non-governmental 457= $19,000
Up to this point, we have saved $102,000. But our goal is $125,000 annually. So, we would then place the remaining $23,000 each year into a taxable account to get to our goal.
First, determine your annual savings goals. Then, fill up the buckets in order.
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What do you think about the order of investing for your retirement? Is there anything you do differently? Leave a comment below.