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The Ultimate Retirement Savings Hierarchy

[Note: For those new to the term, FIRE stands for Financial Independence, Retire Early. The terms 401(k) and 403(b) can be used interchangeably. Please read website disclosure statement if you have not already, which can be read here. I strongly recommend re-reading my posts: ABCs of Retirement AccountsTraditional or RothAfter-Tax IRA & 401(k) Investing, and Is There A FIRE Backdoor prior to reading this post.]

To achieve FIRE, sometimes you have to burn things down. So, torch what you already know about how to save, whether about FIRE or normal retirement, because today’s post will be on the ultimate savings hierarchy for those who have the financial means!

While this is all my opinion, I found it to be the most tax preferential and strategic during my work in the industry. All contribution limits in this post are from the 2021 IRS contribution limits. You may notice that I have ignored saving for other goals, such as educational or significant one-off expenses; this was intentional as this post is about financial freedom. Suppose you plan to save for your child’s education as a top priority. In that case, I suggest you consider it after reaching and maximizing the HSA account stage in this list (Step 4). But enough with the rambling, let’s get onto today’s post!

Where To Save, A Definitive Guide for Financial Freedom

Step 1

Many financial buffs will tell you to pay off any debts you have before you start saving; I wholeheartedly disagree. Why? What interest rate do you have that exceeds 50 or 100% for a credit card, student, or home loan? Exactly, you don’t. Hence, why my first step in saving for financial freedom is to take advantage of any company match your employer provides through your 401(k) or HSA account. 

While some employers provide no match, plenty do. If you happen to fall into this group of receiving any company match, take advantage of it! For example, if your company offers you 50 cents for every dollar you put into your account for the first 5% of your pay you put in, do it! If you have loan sharks or payday lenders charging you more than this amount, pay those debts off and NEVER do business with them again.

Step 2

Alright, we have now taken advantage of any free money available through your company’s match. We are now ready to tackle your high-interest debts! 

When it comes to borrowing money, I am a believer in strategic leverage. What does this mean? Essentially it boils down to the fact that some debts can make you rich rather than poor. Think of debts as sweet and sour flavors; sweet is rewarding (good), while sour bitter (bad). 

Certain financial gurus preach of paying off all debts before saving a dollar, including home loans. I challenge this assertion as being counterproductive at best, downright harmful at worst. While the mentality starts logically by paying off your debts to provide a sense of freedom and accomplishment, it is illogical because you are losing money in the long run. Did I catch your interest yet? Great, let me explain.

Bad debt is anything that you cannot reasonably expect to beat when you invest your savings. An example of this would be a 25% credit card loan you have. Unless you are a magician and able to pick investments that consistently return this much, you should assume a more reasonable investment return so you can arbitrage the difference. Translated to English, if you have debt that is 5%, but you get 6% on the money you invest, it makes more sense to pay off the 5% debt while investing your money at the 6% return since you earn 1% more doing this. This difference is called the opportunity cost. 

So, what interest rate should you assume? That depends on your portfolio, but I like the standard-bearer of investments which is the total US stock market, which traditionally returns ~9% a year. I then want to factor in inflation since it makes these returns less, and I use the annual figure of 2%; thus, this leaves us with a modest 7% return. If your debts exceed 7%, as in my example of 25% credit card debt above, you need to pay them off; they are an emergency, as you are hemorrhaging money! 

For those of you with debts bearing lower interest rates than our chosen return figure, it is time to start saving! Think of these loans as being good debts, like a home or student loans. Buying a new car does not fall into this category, even if the interest rate is reasonable! 

Step 3

Now that we have established the first two steps, we can start saving! Here, I advocate that beginners use high-interest rate savings accounts until three months of expenses have been set aside. The reasoning for this is that if you are a beginner and have no cushion to fall on, a significant expenditure (or job loss) could throw you back into the rungs of debt. Think of this savings fund as a parachute that catches you! 

Once you reach the later stages of being a seasoned saver, this step becomes optional. For now, we will assume you do not have a large amount in savings and thus, do this.

Step 4

Woo, we can now move on with investing our savings! This next phase of savings will depend upon what type of health insurance plan you have. Health insurance, what does that have to do with savings? I am glad you asked!

Suppose you are like millions of Americans and enrolled in a high deductible health insurance plan, known as an HDHP for short. In that case, you can contribute to a particular account known as the health savings account, or HSA for short. This account helps you pay for medical expenses but is excellent for retirement savings too! If you happen to be on a non-HDHP plan, ignore this section and move onto the next. 

HSAs are triple tax-advantaged, which is code for being one of the most potent savings tools around! Triple tax-advantaged comes from the fact that money goes in, grows, and comes out tax-free when used for medical expenses. Talk about a great deal! In addition to this, it is the only account that bypasses FICA and Medicare taxes, saving you an instant 7.5% when it comes straight from your paycheck. No other investment account can do this, period. 

But Mile High Finance Guy, I am healthy and have no medical expenses. Well, lucky for you, this money can be used later when they come up or at age 65+ for anything. Suppose you use the funds for anything other than medical expenses at 65. In that case, it is taxed as ordinary income, making this account exceptionally flexible! 

For those who have HDHPs, I encourage you to save up to the $3,600 individual or $7,200 family limit, plus $1,000 if you are 55+. One caveat here is that those who live in CA or NJ will be taxed on any growth from investments they own during that year on a state level, but not on a Federal level. I know this is confusing, but I encourage you to read up more on your local tax code or talk to an accountant if this applies to you.

Step 5

Introducing the 401(k) and 403(b) accounts, where individuals can contribute up to $19,500 a year in any combination of pre-tax or Roth. If you are 50+, you get to add $6,500 to this limit; talk about benefits! 

I believe contributing to either of these accounts at this step is critical because contributions generally are not capped due to income to either, unlike IRAs

Step 6 (Optional)

This section applies to a small subset of the US workforce, so it may not be something everyone can consider. Primarily, those eligible will be non-profit or governmental workers. Are you offered a pre-tax 457(b) or 401(a) plan? Or do you have self-employed income? If yes to either question, read along. If not, skip to step 7.

So, you are one of the lucky few. In this situation, the 457(b) plan allows for contributions up to $19,500 a year, plus an additional catch-up of the same amount, for those within three years of retirement (generally). 

For 401(a)s, assuming they are pre-tax, contributions are elected once and are fixed after that. So, think hard on if you can afford this contribution and, if you can, set it up to the $58,000 a year limit. 

Now our second group of individuals is those who have self-employed income, in addition to their primary job. If this is you, consider a SEP-IRA contribution, which can be up to $58,000 a year (or 20% of your net profits, whichever is less). 

The self-employed 401(k) can be utilized instead of the SEP-IRA. Still, it shares limits with all other 401(k)s you have, meaning you cannot make the $19,500 or $6,500 contributions again. Instead, only profit-sharing contributions are allowed. Have questions on this? Ask an accountant or do online research!

Step 7

Do you still have money left to save? Whoa, good for you. In that case, we will move onto the IRA and Roth IRA accounts. I did not place these two accounts earlier as each step before this one can help lower your income in the government’s eyes. The less you make, the higher your chances of making a deductible IRA or direct Roth contribution. I strongly recommend re-reading the posts linked below before continuing if you are not familiar with the IRA and Roth IRA account rules. 

ABCs of Retirement Investment Accounts & Traditional or Roth,

Individuals offered a 401(k) plan at their workplace cannot receive a full pre-tax deduction when contributing to an IRA if they make above $66,000 a year. If their company does not offer one, they can always contribute and receive a tax deduction. For Roth IRAs, it does not matter whether or not you are offered a 401(k) plan, simply put, if you make above $125,000 a year, you cannot contribute to one. These limits vary based on your filing status and from year to year, so please check this article for more details [ABCs of Retirement Accounts] or the IRS.gov website.

With all this said, if you are eligible to contribute directly to a Roth or make a deductible IRA contribution, do so now! The annual limit for these two accounts combined is $6,000, plus $1,000 for those 50+. If you are interested in backdoor Roth conversions, wait until step 9.

Step 8

We now move onto the spousal IRA account, which applies to married couples where one spouse does not work. In this situation, the spouse can make a pre-tax or Roth IRA contribution of $6,000 a year, plus a catch-up of $1,000 if 50+. However, the Roth is subject to income limits, just as they would if they were making money. 

Step 9

Onto our next section and enter the backdoor Roth conversion! This is an excellent choice for those who cannot directly contribute to a Roth IRA and are disqualified from deductible pre-tax IRA contributions. 

Executing a Roth conversion can be tricky, so it is essential to remember the After-Tax IRA Investing and Roth Conversion basics. Additionally, make sure you have a zero-dollar balance in all traditional, rollover, and SEP IRA accounts. A common way to accomplish a zero-dollar balance is by rolling all pre-tax IRAs into a 401(k) plan you already have.

Once you have a zero-dollar balance in all of your pre-tax IRA accounts, you can now proceed. This first step is to make a $6,000 a year (and $1,000 catch-up for those 50+) non-deductible contribution to a pre-tax IRA and then convert it to Roth. To refamiliarize yourself with this, please read the Roth Conversions post.

Step 10

So, we just did a backdoor Roth IRA conversion. What about the Mega Backdoor Roth? Well, for those lucky enough to have a 401(k) that offers after-tax contributions and conversions, this is for you. To calculate how much one can contribute via the Mega Backdoor Roth, we start with two limits: The first is the $19,500/year individual limit, and the second is the $58,000 overall 401(k) limit; the catch-up $6,500 is ignored in these calculations, as are the SEP-IRA, 457(b), and 401(a) limits. 

We now have our overall limit and our pre-tax/Roth limits, so to determine how much after-tax you can contribute, we take $58,000 a year and subtract out $19,500. We are now left with $38,500, but we now must subtract out any company contributions made to your 401(k) plan. Whatever is left is the amount you to use for the Mega Backdoor Roth conversions.

Step 11 (Optional)

The following three types of savings that I will cover are optional and include: Employee Stock Purchase Programs (ESPP; for workers at publicly traded companies), Non-Qualified Retirement Plans (NQRP; for high-income earners and executives), and deferred annuities/permanent life insurance policies (for those who are absurdly wealthy). These three accounts generally allow for unlimited contribution amounts. Still, they carry high risks and, as a result, require your discretion. 

ESPPs and NQRPs can make sense for a variety of reasons. Still, the most popular include discounted company stock prices for ESPPs and pre-tax deferrals/tax-deferred growth for NQRPs. However, they are optional because they involve considerable risk compared to standard investment accounts. With ESPPs, the company stock price can go to zero, and with NQRPs, the savings can disappear if the company goes bankrupt. 

As for deferred annuities and permanent life insurance accounts, these are optional because very few people can truly benefit from them. While this is my opinion, there is a reason why annuities and permanent insurance get a bad reputation. They are often oversold and used by consumers who do not get the actual benefits that can be derived. Importantly, they are not a forced savings account, so please do not buy into this premise. 

These types of accounts will benefit those who make stratospheric levels of income or have amassed estates that would be subject to the estate tax (for those worth more than $12,000,000). Unless you happen to be in one of these two situations, I suggest you consider skipping these. 

Step 12 – Final Step!

We made it to the final category, which is good old-fashioned, non-tax preferential brokerage accounts. These accounts have unlimited limits and have no early withdrawal penalties since they are meant for any purpose and not just retirement. Saving here is a powerful tool that anyone can utilize before any steps in an earlier stage! If you need a refresher on these accounts, please re-read my ABCs of Retirement Accounts article. Notable benefits of this category include long-term capital gains tax rates and unlimited investment choices.

So, to summarize this post, save where you can get tax-preferential treatment first, and then invest! To make this article easier, I have included a table below to be used as an easy reference guide. While many sections may not apply to you, skip them and utilize the ones that do. This post is meant to be as broad as possible and help you on your journey to financial freedom. Tell me in the comments whether or not you agree with my order or if you have a better suggestion. As always, have a great day!

A List of Where to Save

AccountAmountReasoning
401(k) & HSA up to Company MatchWhatever your company matchesFree money that beats interest rate of any debts
High-Interest Debts/LoansDebts with interest rates exceeding 7%Stock market returns 7% on average each year, if debt is above this you need to pay it off
Emergency SavingsThree months of essential expensesA buffer to prevent you from falling back into debt
HSA: Health Savings Account$3,600 individual $7,200 family ($1,000 catch-up for 55+)Triple tax advantaged: Money goes in, grows, and is taken out tax free if for medical.
401(k)$19,500 Pre-tax or Roth ($6,500 catch-up for 50+)High contribution limit, can make you eligible for IRAs
457(b)$19,500 Pre-tax (Generally catchup of $19,500 if you’re within 3 years of retiring)Only available for governmental or non profit employees, but is an great pre-tax way to save!
401(a)$58,000Once you elect this contribution type, it is mandatory until you quit. Growth is tax deferred, only use here if pre-tax.
SEP-IRA20% of net profits up to $58,000Self-employed income required. Tax-advantaged for growth and contributions for those with self employed income.
SE-401kUp to $58,000 ($6,500 catch-up for 50+)Self-employed income required. $19,500 and $6,500 limits are shared by your primary 401(k), but your self-employed business can profit share an additional $38,500 into this on a pre-tax basis.
IRA or Roth IRA$6,000 plus ($1,000 catch-up for 50+)Must be eligible for regular contribution to use in this step. Tax-advantaged for growth and contributions.
Spousal IRA (if non-working)$6,000 plus ($1,000 catch-up for 50+)Must be eligible for regular contribution to use in this step. Tax-advantaged for growth and contributions.
Backdoor Roth IRA$6,000 ($1,000 catch-up for 50+)If not eligible for deductible IRA or direct Roth contributions. Must have a $0 balance in all pre-tax IRAs prior to converting after-tax dollars.
Mega Backdoor Roth 401(k)$38,500 (less any company contributions)Company must offer after-tax contributions and allow for conversions in plan or to Roth IRA. If offered an after-tax 401(a), do it here for backdoor conversions as well.
Optional: ESPPUnlimited (but risky)Employer offers an ESPP program that is lucrative, the stock is not highly volatile, and the holding requirements are not a burden.
Optional: Non-Qualified Retirement PlansUnlimited (but risky)Employer offers an NQRP. Made pre-tax and provide tax-deferred growth. If the company fails, your money disappears.
Optional: Deferred Annuity or Permanent Life InsuranceUnlimited (generally not suitable)You probably should skip this step unless you are exorbitantly wealthy. Please read post for reasoning.
Non-Retirement Brokerage Account (i.e., regular after-tax investment account)UnlimitedHolding investments for one year or more gives you access to long-term capital gains rates, and there are no penalties to withdrawing ever.


Mile High Finance Guy

finance demystified, one mountain at a time






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