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What to do with your money – 401(k), HSA, IRA, Roth IRA, Emergency Fund, Debt? The Right Sequence!

Many people have this question of where they should invest money first.

It really depends on your situation, on your age, on your current income, on your projected future income, current income tax rates, and future expected income tax rates.

Currently, federal tax rates are at an all-time low. Most pros agree that in the future tax rates will be at a little higher level. Although another agreement is that standard deduction and other deductions will also be higher. Also, the tax brackets will have higher income limits.

There is no exactly optimized way but there is some obvious sequence of what you should do with money and how you should fund the different types of retirement accounts.

Few reasons why we can not have a 100% sure-fire way of predicting an optimized strategy of funding these retirement accounts

  1. Your future income might change and is hardly predictable with accuracy…proof? Look back 5 years…were you certain at that time that you are going to earn what you are earning now. If we can not be certain of our income levels in 5 years, how can we be certain in the next 20-40 years?
  2. Federal Income tax rates: No once can predict what income tax rates would be in 20-30 years.
  3. State Income tax rates: Maybe right now you are in California (very high marginal tax rate) and will retire in Texas or Nevada (zero state income tax rates)
  4. Retirement account rules change and change often. Recently the age for RMD ( required minimum distribution from IRAs) was raised from 70.5 to 72. Maybe in 20-30 years, it will be 80!

But still there is some strategy on how you do it. This is a good rough strategy that should be good for most people.

Essentials

As money comes in from your paycheck or business you have to take care of essentials – food, rent/mortgage, education, clothes etc.

I will throw in some non-essentials things that increase happiness it could be traveling, dining, cruises (or maybe not after COVID-19), charity, gifting to others, etc.

If you are not doing these fun things why are you even working?

Emergency fund

After essentials there should be emergency fund.

Some people start paying credit card bills but it’s better to have some cash in the bank and keep paying those high-interest rates. WHY? It doesn’t make financial sense to make emergency funds while you are paying sky-high interest rates of credit cards…but don’t you want peace of mind? I was in debt in 2007 paying 13-20% on the credit cards but I still did not move my funds from emergency fund to CC debt.

Look: The emergency fund is there for a reason – for emergencies – having a CC debt is not an emergency! Agree?

Of course, you shouldn’t have had that CC debt in the first place…its a bad debt and we will handle it next.

How much should you save in Emergency Fund?

Most personal finance websites suggest 3-6 months of emergency funds. But whoever is suggesting is giving a ballpark estimate of “what they think” …other people just copy this 3-6 month estimate and go on with their life. Have they lived with 3 months of an emergency fund – don’t ask them that’s not their job. So let me tell you this…you need at least 8-12 months of an emergency fund or 2 years if better. WHY?

See if you get fired or laid off from your job you would be in a shock for a week to a month – You do not want to take up any job. Now that you are fired you have less of a bargaining chip and you are more desperate to get that job…so to get a good job …a satisfying job you do not need the extra pressure of funds dwindling day by day.

So start saving. There are many rewards accounts (check out doctorofcredit.com) that pay a lot more than a high-interest savings account. Currently, as of April 2020 Ally’s online savings account is paying 1.5% while Kasasa cash checking accounts are paying 3-4% up to 25/50K!!

TIP: Do not put your emergency funds in big banks like Chase, Bank of America, Wells Fargo since their regular checking account pays 0-0.05%!

Bad Debt

Bad debt is which is non mortgage related usually and usually.

Example of good debt:

  1. Debt for purchasing your home.
  2. Debt for purchasing your fourplex.
  3. Business loan if you are going to own cash flowing commercial property.
  4. A small business loan that has a good chance of breaking even in 1-2 years.
  5. Student loans in which you are making a minimum payment with reasonable interest rates.
  6. Line of credit which you are not using but it is there in case you find a good business deal!

Examples of bad debt:

  1. Credit Card debt which usually charges 8-25%!
  2. Payday loans, Pawnshop loans, and such.
  3. Buying depreciating assets (cars, furniture, etc) on credit…always buy a car in cash with whatever you make pretax in 1 month….yes you can get a Lamborghini if you are making 200K a month – yes people do that…people make that…don’t have a limited small mindset…really bad for growth. You can get a BMW when you are making 70K per month. But never buy a car on credit.

Start with higher interest rate debt first and then go to lower interest rates. This is what makes the most financial sense. Although psychologically its better to pay off and check off from you list a smaller balance.

Warren Buffet in his 2020 annual shareholder meeting said “I don’t know how to make 18%. If I owed any money at 18%, the first thing I’d do with any money I had would be to pay it off.” (i.e. the credit card debt!)

So do not start investing before you have cleared off all your bed debt!

HSA Match

If your employer offers a high deductible health plan and a match for an HSA pounce on it!

That’s free money …and never taxed… it’s not tax-deferred like a 401k account. It’s better! You never pay tax on it if you use if for medical expenses. I do not know about you but I still have to find someone who doesn’t expect the medical expenses to be their biggest expense when they get older!

Usually, the employer will either contribute to your HSA without your contribution or will match your contribution up to a certain limit.

401(k) Match

Most employers who offer an employer-sponsored retirement account like 401(k) or 403(b) usually offer a match.

Sometimes its employer contribution without any matching contribution from you. However, most likely it is in one of the two formats:

  • 100% match up to 5% of your salary – means you put 5% of your salary in that 401(k)…employer will plow in the extra money too.
  • 50% match up to 3% of your salary – means you put in 6% of your salary and employer will follow with 3% match (= 50% times 6%)

HSA

Now you need to fill-up your HSA tank full up to your HSA contribution limits.

This is free money and you do not want to leave it on the table.

Note that HSA is no tax in and no tax out. While 401(k) is no tax in and tax out!

So HSA is better. Some people at this step think to contribute to 401(k).

401(k)

For the year 2020, the max employee contribution limit is $19,500. If you are over 50, an additional $6,500 contribution room is available to your 401(k) plans. That’s a lot of tax savings if you are in a higher marginal tax bracket.

Remember for 401(k) and other similar deductions you should be comparing your current marginal tax rate with your future guessed effective tax rates.

You need to do things….be smart about how you contribute to your 401(k) and contribute the max amount you can ASAP.

Some people think 401(k) is tax-free…no it’s not…its tax-deferred. You will have to pay the tax…not just now.

It also doesn’t make sense when you are in very low-income tax brackets!

So skip it if you are barely making money! If you are marginal tax rate is 10% or 12% you do not need this 401(k) why….because I am assuming you believe in these two things: You want to earn substantially more in the future AND effective income tax rates will be higher in the future – since currently, they are too low.

Believe me, I made this mistake when I was in a low tax bracket of 15%…and now when I am in a higher tax bracket I feel it would have been better if I hadn’t contributed to my 401(k) in those years! Learn from my mistakes! or make your own 🙂

Now let’s look at twists on 401(k).

Note that 2nd-4th twists are more geared towards people who make more than $200,000. This means they have contributed the regular 19.5K and still have money left and they are in high tax bracket and want to reduce their income taxes or are looking for tax-saving opportunities.

1st Twist on 401(k) – Roth 401(k)

First is Roth 401(k) …just like there is IRA (traditional) and Roth IRA…similarly there is Roth 401(k). Some employers allow this. Bigger companies will let you know about this however in medium-size and small companies you would have to ask HR or 401(k) sponsor – and it’s possible they wouldn’t know so they would have to ask the 401(k) custodian. You would have to find out that if your 401(k) allows the Roth 401(k) contribution option.

Roth 401(k) contribution means you are contributing to a separate account from your 401(k) with the after-tax money.

This means that you are not deferring tax on your full limit of 401(k) contribution. Note that the max employee contribution of 401(k) is the total of regular and Roth 401(k) contribution.

2nd Twist on 401(k) – Employer Match 401(k)

For 2020 the maximum employee contribution is $19,500. BUT the real secret is that some employers have employer matching contributions and employer nonelective contributions usually for highly paid employees. And this way employer can top off the 401(k) to $57,000 for 2020!! Yes, 57K…no that’s not a typo.

This also works if you have a business and have a solo 401(k). You can make your regular salary deferral 401(k) contribution and then contribute as an employer contribution up to $57,000 for 2020.

3rd Twist on 401(k) – Mega backdoor Roth IRA

Again this strategy is for people earning $200,000+. This is a good article for mega backdoor Roth IRA.

4th Twist on 401(k) – Having multiple 401(k)s!

So the contribution limits to 401(k) plans are per employer. Let’s say you are working part-time with your employer and also you run a side hustle or some business where you have your own “Solo 401(k)”. In this Solo 401(k) you can separately contribute up to $57,000 (for the tax year 2020). This list is not reduced by the contribution you make in your employer’s 401(k).

The following two examples are from IRS website:

Example 1: In 2019, Greg, 46, is employed by an employer with a 401(k) plan, and he also works as an independent contractor for an unrelated business and sets up a solo 401(k). Greg contributes the maximum amount to his employer’s 401(k) plan for 2019, $19,000. He would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $19,000. He would also like to contribute the maximum amount to his solo 401(k) plan.

Greg is not able to make further elective salary deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $19,000, to his employer’s plan. However, he has enough earned income from his business to contribute the overall maximum for the year, $56,000. Greg can make a nonelective contribution of $56,000 to his solo 401(k) plan. This $56,000 limit is not reduced by the elective deferrals Greg made under his employer’s plan because the limit on annual additions applies to each plan separately.

Example 2: In Example 1, if Greg were 52 years old and eligible to make catch-up contributions, he could contribute an additional $6,000 of elective deferrals for 2019. His catch-up contribution could be split between the plans in any proportion he chooses. Or, Greg may contribute the full $6,000 catch-up contribution to his solo 401(k) plan, making a total contribution of $62,000 for 2019. This is because, although he made nonelective contribution to his solo 401(k) plan up to the maximum of $56,000, the $56,000 limit is not reduced by the elective deferral catch-up contribution

529 (Education) Plan

529 is a great tax advantage savings plan if you want to save for college for your kids or yourself…or any other relative.

These plans are sponsored by states, agencies or educational institutions.

The are two flavors in 529 plans:

Prepaid Tuition Plan

This plan lets you purchase credits at participating colleges and universities for future tuition at the current prices — talk about having a grip on inflation! It is very similar to buying those FOREVER USPS stamps!!

Most prepaid tuition plans are sponsored by state governments and have residency requirements for the saver and/or beneficiary. Prepaid plans are not guaranteed by the federal government. Some state governments guarantee the money paid into the prepaid tuition plans that they sponsor, but some do not. If your prepaid tuition payments aren’t guaranteed, you may lose some or all of your money in the plan if the plan’s sponsor has a financial shortfall.

Also, note that prepaid tuition plans usually CAN NOT be used to pay for future room and board at colleges and universities and do not allow you to prepay for tuition for elementary and secondary schools.

Prepaid plans generally have enrollment/application fee and ongoing administrative fees.

Education Savings Plan

Now, this type of 529 plan is better since you are not putting money at risk based on the financial status of the college or university!

Also, you can save money tax-free for all the qualified higher education expenses like tuition, room, and board; mandatory fees; and, books, computers, and software (if required).

ESP can also be used to pay for elementary and secondary schools!

ESP plans can have enrollment/application fee, annual account maintenance fees, ongoing program management fees, and ongoing asset management fees.

Now whether you choose the prepaid or education savings plans make sure that whichever plan you are choosing has lower overall fees.

IRA

Now you can not contribute to the IRA if you already have a 401K. 401K is much better than an IRA because of no income limits!

Let’s say you do not have 401(k) then you start contributing to your regular traditional IRA. Also, you have the option to contribute to Roth IRA without worrying about 401(k) conditions.

Roth IRA you do not get any deductions but the growth is tax-free. When you take out money the contribution comes out tax-free (since you have already paid tax on in) and only the earnings are taxed.

The annual limit applies to contribution to IRA both Roth + Traditional and changes every year.

If you are ineligible because of income limits to contribute to Roth IRA look into backdoor ROTH IRA. It is very popular among six-figure earners.

Regular Investment Accounts

Now here you could go with a regular investment accounts.

I have regular investment accounts with multiple brokers. See the recommended list of brokers here.

It’s better to separate your accounts into short term and long term.

Maybe you want to do long term investment – keep them separate. Do not mix those accounts with the swing trading or day trading accounts.

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