Hi Friendos,
Today I would like to start a discussion about types of tax-advantaged investment accounts, like 401k’s, IRAs, and HSAs, and how to decide which type of account you should put your money in. I have always been a huge booster of such accounts, so it may surprise you to learn that I believe the existence of such accounts is terrible policy and we should get rid of all of them! It seems clear to me that these accounts are a way to let the rich avoid paying their fair share of taxes under the guise of helping the middle class with a few crumbs (the poor get nothing from all this). But here we are, with this alpha-numeric soup of account types, so I’d like to help you navigate things the best you can and make use of the financial support on offer.
Most people are not able to max out every type of tax-advantaged account they have access to because they need most of their income to meet living expenses. Today we’ll look at an example of someone with access to (1) a 401k/403b, (2) an HSA, and (3) an IRA, but unable to contribute the full $34,150 that would max out all three accounts. How should they prioritize their retirement saving?
In 2024, you can put in a maximum of $23,000 into a 401k/403b if you are under age 50 or $30,500 if you are over 50. Imagine a single person with no dependents who makes a healthy income of $100,000. How many people can actually set aside 23% or 30.5% of their income? That high savings rate might be quite difficult for a single person to achieve (it would depend heavily on their cost of housing) and may be completely out of reach for anyone paying for child care, elder care, student loan payments, a chronic medical condition, or other common expenses. Even more so when we consider that median household income in the US is under $80,000 per year.
So let’s extend this example of our single person with no dependents (we’ll assume they are under age 50 and have a 401k at their job). Assume they prepared a budget (a spending plan for the year) and determined they will put away $15,000 toward retirement this year. In 2024, they could contribute a max of $4,150 to their HSA and a max of $7,000 to an IRA, meaning they could, in theory, stuff a maximum of $34,150 into these three tax-advantaged accounts – a lot more than the $15k they have planned. How much should they put into each account?
This is my suggestion:
- If they get any 401k employer matching, they should plan to contribute enough to the 401k to get all the matching. Example: if their employer matches them 50% up to 5% of their income, that means our $100k earner should contribute $5,000 to retirement in order to get the full $2,500 of employer match.
- Then plan to max out the HSA for the next $4,150.
- Then put the remaining $5,850 into the 401k (=$15k – $5k – $4.15k) and nothing into the IRA (if they like the IRA account better, they could put the rest there instead of the 401k).
Now that’s not going to be the literal order of cash flowing into the accounts. What this person will actually do is set up a particular amount to come out of each paycheck. Under my suggested plan, they’ll contribute an annual total of $10,850 to the 401k and $4,150 to the HSA. Take those amounts and divide by the # of paychecks during the year, and that’s how this plan would actually be implemented.
Why do I prioritize the employer match over the HSA? Because an employer match is a guaranteed 100% return on investment and part of your compensation. No further math required for the analysis. Never leave an employer match on the table if you can remotely help it.
After that, why prioritize the HSA over the 401k? Because an HSA offers the chance to earn income that is never taxed at all. Of course, this is only worth pursuing if a high deductible health plan is the better deal for you (I wrote a series of articles about evaluating health plans last fall). Think of your HSA as a different kind of retirement account, turbocharging its use, and it takes on a whole different look.
Another key benefit of an HSA over a 401k is the possibility of using it as a kind of emergency fund. Let’s say you’re using an HSA in my preferred manner: you budget separately for medical expenses, and leave your HSA contributions to grow inside the account, invested in low-cost index funds. You save receipts from qualified medical expenses so that in the future, you can reimburse yourself for those expenses. If you have some kind of emergency, you can reimburse yourself from your HSA at any time with no penalty. If you raid your 401k, you may have to pay an early withdrawal penalty if you are under age 59.5 and have to pay income taxes at that time as well.
I do not think it is wise to plan on raiding retirement savings for other purposes, but sometimes life throws things at us. Considering that one survey found a majority of people do withdraw from retirement accounts early at some point, I’d rather they avoid the 10% penalty. The ability to withdraw contributions from a Roth IRA without penalty is a point in its favor, a topic we’ll get into in another article.
Why prioritize the 401k over an IRA? Saving and investing via automated payroll deductions is more likely to result in the money actually being set aside. It is easier for most people to budget for setting aside regular, small amounts than trying to save up a big lump to invest all at once, and easier to make one good decision (set up 401k contributions) than many good decisions (keep putting $ into an IRA). Can you automate IRA investments? Of course! It’s just a bit more onerous for most people to get that done vs participating in an employer 401k. What if you disagree and like your IRA better than your employer 401k? Then by all means, prioritize your IRA! It is equally good at helping you avoid taxes.
Whatever your personal situation, if you are saving for retirement at all, you are already doing the most important thing to provide for your future self. After taking that important first step, you can fine tune by prioritizing which type of account to save into, considering the types of accounts that are available to you.
-Stephanie
Frequently Taxed Questions 