You ever unsure what to do with your excess money that you want to use for investing for retirement? Ok, I wanna help.
Here’s the simple ranked choice way to do something with your money.
- Pay off high interest debts
- 1 – 12 months expenses in a high interest savings account
- Roth 401k (if a match)
- 401k (if a match)
- Roth IRA
- Roth 401k (if no match)
- IRA
- 401k (if no match)
- Solo Roth 401k (if eligible)
- Solo 401k (if eligible)
- SEP IRA (if eligible)
- Brokerage
- Low Interest Debt
Let’s break these all down a little and see if I can help you understand why you want to do each, and why I’m ranking them where I am.
Pay Off High Interest Debts
High interest debts are going to drag your income growth. If you’ve got a $10,000 in credit card debt, it doesn’t matter how well you invest, or how well your investments are tax advantaged. Servicing that debt, and the interest is going to cause you to lose significant money.
Pay off your high interest debts, or at least start to make aggressive repayments while investing.
1-12 Months Expenses in a High Interest Savings Account
You need some savings for a rainy day. It’s going to come, a surprise medical bill, a car repair, a job loss, whatever. It’ll happen. Having some cash buffer to deal with these issues and have it not wipe out all your cash will make a difference. Also, you don’t want to slide back into accumulating high interest debts.
How much cash savings you have depends a lot on your personal situation. If you’re a freelancer, you’ll probably want to be on the higher end of cash savings. If you’ve got a really stable job, perhaps multiple streams of income, maybe you can be on the lower end. But having some cash is never a terrible idea. And it also gives you the optionality to deploy cash into other tax advantaged accounts as you see opportunities.
Personally I think just start small if you don’t have much cash saved. Start with a month, invest in some of the below, then get another month, and another, and so on. In no time at all you’ll build a good little cash buffer.
Roth 401k (if match)
Ok! now we get into fun ways to save money.
A 401k is an employer sponsored retirement account that employees can contribute to. Typically these are optional accounts you can set up with a employer, though not all employers offer them. They typically allow you to invest in a variety of mutual funds or ETFs. And sometimes companies offer MATCHING which is the key to if you should invest your money here first, or go for the ROTH IRA first.
Matching is when a company says they’ll match your investments in a 401k. A few ways I’ve seen companies offer matching is include, 100% matching of up to 4% of your salary, or a percentage of your contributions e.g. 25% of 100%, so if you save 4%, they’ll contribute an extra 1%.
Matching, at basically any level, is like getting free money. If your company offers 4% matching your 4%, if you invest your money when your employer matches your technically getting a 100% return on your investment immediately. That’s huge.
If the company offers matching, you need to take advantage of the match. If a company matched 100% of my income, you better believe, I’d put in 100% of my income. It’d be such a great instant return it’d be impossible to turn down. Take advantage of the match.
Now the Roth of it all. Ok, basically a Roth account allows your money to grow tax free. So if you invest $100,000 into a Roth account, and it grows to $1,000,000 by the time you retire, you do NOT pay taxes on you $900,000 of capital gains. In the USA, capital gains tax can be as high as 20%. So your $900,000 of gains, Uncle Sam’s gonna get his taste to the tune of $180,000. You put your money to work for the government. (no shade on the government, we should all do our part, but your retirement ain’t the place to do it.) With a Roth IRA if your investments grow to a $1,000,000 or a $1,000,0000,000 the tax on that is ZERO. Meaning you’ll keep more of your money (assuming you withdraw capital gains after the age of 59). That’s huge.
The traditional 401k does not offer that tax protection, but it has a different offer for you.
401k (if match)
Ok, so everything I said about matching above still applies. So just, take that all over.
A traditional 401k, your capital gains will be taxed. So that’s a bummer. For most people, I believe, that makes the traditional a worse option. But the traditional allows you to reduce your tax burden in the present, meaning you can write off your contributions to your 401k.
Briefly, (again I’m not a tax expert), but a write off means you’re lowering your taxable income, not reducing the amount you have to pay. So if you invest $5,000 in a 401k, and you make $55,000, you’re only going to get taxed on $50,000 of your income. It does NOT mean you lower your tax bill by $5,000.
Typically you can in either a Roth 401k or a Traditional 401k with most employer sponsored retirement plans, or a combination of the two. I’ve seen and heard of a few that only offer one, or only offer MATCHING in one. If you can get that free match, you probably should.
Roth IRA
A Roth IRA is my favorite thing in the world. At my job I speak to a lot of young people and they ask my advice on all kinds of stuff. Really the only half way good advice I have is get a Roth IRA, and put some of your extra money in it, as soon as you can. Right now, just do it. Trust me. Jesus. Do it.
The only reason a Roth 401k or a Traditional 401k with a match is above the Roth IRA is there’s free money being provided by an employer. It’s just too good of a perk to pass up.
But a Roth IRA allows you to have the benefit of not paying any tax on capital gains on money invested in a Roth IRA (assuming you withdraw capital gains after the age of 59).
How ever you do not get a write off for Roth IRA contributions..
The Roth IRA also allows you to withdraw your PRINCIPAL investment at any time with no penalty no tax. Meaning if you contribute $6,000, invest it, and a bit later you go, oh shit I need that $6,000, you can withdraw that principal investment with no penalty no tax.
Max contribution to an IRA annually is $6,000. Max it if you can. It’s like a savings account in some ways, if you need the cash from it down the line, you can get it. Now if you invest it all in penny stocks and it goes to $0, well then, no you can’t withdraw it. But hopefully you have a better investment strategy than that.
Roth 401k (if no match)
Repeating a lot of the above on the Roth 401k advantages, but without a match, your employer isn’t contributing to your 401k, which is too bad.
A 401k is an employer sponsored retirement account that employees can contribute to. Typically these are optional accounts you can set up with a employer, though not all employers offer them. They typically allow you to invest in a variety of mutual funds or ETFs.
Now the Roth of it all. Ok, basically a Roth account allows your money to grow tax free. So if you invest $100,000 into a Roth account, and it grows to $1,000,000 by the time you retire, you do NOT pay taxes on you $900,000 of capital gains. In the USA, capital gains tax can be as high as 20%. So your $900,000 of gains, Uncle Sam’s gonna get his taste to the tune of $180,000. You put your money to work for the government. (no shade on the government, we should all do our part, but your retirement ain’t the place to do it.) With a Roth IRA if your investments grow to a $1,000,000 or a $1,000,0000,000 the tax on that is ZERO. Meaning you’ll keep more of your money (assuming you withdraw capital gains after the age of 59). That’s huge.
The traditional 401k does not offer that tax protection, but it has a different offer for you.
Traditional IRA
If for some reason you cannot contribute to a Roth IRA (basically being too high of an earner) guess, what. Traditional IRA. Do it. The good news is as of now you can contribute money to a traditional IRA, invest it, take a TAX DEDUCTION on your contributions. Then when it’s been in the Traditional IRA for a little bit, you can do a backdoor Roth IRA conversion. Now you’ll have to pay some taxes to do the conversion, so expect that, but that investment will grow with no tax on the gains. It’s an such a valuable investment vehicle to get in a Roth IRA, I can’t emphasize enough that you need to do it.
401k (if no match)
A lot of this is a repeat of the 401k with match, but cutting the matching details. OK!
A traditional 401k, your capital gains will be taxed. So that’s a bummer. For most people, I believe, that makes the traditional a worse option. But the traditional allows you to reduce your tax burden in the present, meaning you can write off your contributions to your 401k.
Briefly, (again I’m not a tax expert), but a write off means you’re lowering your taxable income, not reducing the amount you have to pay. So if you invest $5,000 in a 401k, and you make $55,000, you’re only going to get taxed on $50,000 of your income. It does NOT mean you lower your tax bill by $5,000.
Typically you can in either a Roth 401k or a Traditional 401k with most employer sponsored retirement plans, or a combination of the two. I recommend Roth first.
Brokerage Account
Ok, so now you’ve done your most tax advantaged, dollar advantaged contributions, and you still need to do more? Well, congrats. We’re getting to the end of the list here and I’m not sure these recommendations get much better at this point.
Drop some money into a brokerage account. If you use something like Wealthfront, you can get some tax loss harvesting which is nice, but hard to get many tax advantages at this point. Still, saving money in a brokerage account is great. I also use a brokerage for part of my emergency fund investing some money in a relatively low risk portfolio so I can grow some of my emergency savings (just in case I never need it).
Low Interest Debt
You should pay off your debt. But I wouldn’t rush to do it. The annualized return of the S&P500 since 1920 is about 10%. Meaning if you put $1,000 into the stock market on any given year, you could reasonably expect a year later it’d be worth about $1,100. And $1,210 a year after that.
But when you have debt on a car, or a student loan, or a house, maybe your paying 3%-6% interest. In that case, you’d be better making minimum payments (or more if that makes you uncomfortable) and putting any extra payments your thinking about using to pay off low interest debt into one of the other accounts mentioned above. Again, you’ll likely make ~10% a year, so extending the term of your debt is probably ok since you’d likely make that money.
Now admittedly, some of this is about your personal risk tolerance, and how long you think you’ll be working and making money. If you’ve only got a couple years left of working and you wanna get the debts off your plate, then by all means, that makes sense. But if you’re young and like me think of all debt as a boogyman, I’d reconsider.
