This thread is for those members who are nearing-or-in retirement to provide advice/tips to those who are just getting started. No advice in this thread should be assumed to be correct, without additional verification (e.g., discussion with an independent financial advisor). Personally, I'm currently looking to understand how to protect assets from being considered in the needs-based Medicare qualification test for long term care. I will edit this post with additional member contributions, to create a one stop primer on multiple topics. So let's get it started with what I consider "the basics", and build from there. Thanks in advance for the additional thoughts!
The 401(k)
A 401(k) is a retirement savings plan that uses pre-tax dollars from your paycheck, thereby enabling tax-deferred investment growth on that money. Upon withdrawing that money at retirement, the principle and growth will be taxed as income when is generally assumed that your tax rate will be lower. For example, it you are being taxed at a 28% rate today and upon retirement you will be in a 15% tax bracket, then you have already saved 13%. The 401(k) is the vanilla plan for many potential retirees, but it is hard to remove money from the plan without having penalties assessed against you. If you pull money out before age 59.5, you will owe income tax on the amount withdrawn + a 10% penalty. The CY2018 maximum annual contribution is $18,500, with an additional $6,000 catch-up contribution allowed for those 50 years and older.
Many employers offer a 401(k) matching contribution, such as a 50% match for the first 6% of your salary. This is “FREE MONEY”, and I always recommend that everyone contribute enough in the 401(k) to get the maximum employer match. Beg, borrow, and find a way to make it happen, and never leave free money on the table if you want to retire at some point in your life! Note that I didn’t say to maximize the full 401(k) contribution immediately, just enough to get the maximum employer match for starters. There are other choices to consider once the free money is in hand. More on that later.
It is possible to obtain an up-to-5Y loan from your 401(k) from your employer, provided that you are still employed by them. That loan period is longer for purchase of a primary residence. There is a lot of debate in this area, so others who have done this will be able to provide better advice. There are also ways to access your 401(k) earlier (e.g., Rule 72T), but those really should be discussed with an expert.
The Roth Individual Retirement Account (Roth IRA)
The Roth IRA is another retirement vehicle where you put post-tax dollars into the account and the investment growth on those dollars are not taxed upon retirement. Not taxed at all, ever. This is such a good deal that the IRS maximum contribution for CY2018 is $5,500 (+ $1k if you are over age 50). If you are early in your career, the advantage is that your tax rate is likely lower to begin with so your investment growth is compounded.
Because the principle in this account has already been taxed, you can withdraw the principle at any time, for any reason, with zero penalties. This is a huge advantage over the 401(k). You can’t put that principle back once withdrawn, but the Roth IRA is essential a huge safety net that is readily accessible. Additionally, withdrawals from a Roth IRA do not count as income. That doesn’t sound like a particularly big deal, but we will talk later about why it’s very big.
The IRS says they restrict participation in the Roth IRA for high earners, and begins to phase-out the ability to fund a Roth IRA if you have a Modified Adjusted Gross Income (MAGI) up to $133k; but there’s a huge loophole called the Back-Door Roth that was “overlooked”. In my opinion, a “wink wink” deal was cut such that the IRS still allows the highest earners to fund a traditional IRA, and convert it to a Roth IRA. It takes just a few minutes, and will likely be the best few investing minutes of your year. Every few years you hear rumblings about the IRS closing the Back-Door Roth, but it’s still open today.
If you haven’t contributed to a Roth IRA yet this year, you still have until the annual tax filing deadline to do so (i.e., 18April2018).
The Heath Savings Account, for high deductible health care plans (HSA)
For those with a high deductible heath plan, a Health Savings Account allows you to put away pre-tax dollars to pay for future health care expenses. It’s the only non-annual mechanism that creates a savings that is never taxed. Cafeteria Plans are annual use-it-or-lose-it accounts, but the HSA has no such annual clearance requirement. Most HSA Accounts also have investment options, so not only is the HSA principle never taxed, but the returns avoid all taxation as well. It’s a very powerful tool, as incurring health expenses at older age is essentially a certainty.
About Expense Ratios
When selecting mutual funds, be careful about funds with high expense ratios. Some of these funds quietly take a full 1% per year (or more) of the total amount in the fund for their management costs. Contrast this with something like a Vanguard Admiral Shares Index fund that takes 0.03% per year, and the savings become massive over a 20+ year period. It’s hard for large funds to beat the street in terms of market returns, so paying extra with no guarantee is a bit of a gamble.
TLDR Version
The 401(k)
A 401(k) is a retirement savings plan that uses pre-tax dollars from your paycheck, thereby enabling tax-deferred investment growth on that money. Upon withdrawing that money at retirement, the principle and growth will be taxed as income when is generally assumed that your tax rate will be lower. For example, it you are being taxed at a 28% rate today and upon retirement you will be in a 15% tax bracket, then you have already saved 13%. The 401(k) is the vanilla plan for many potential retirees, but it is hard to remove money from the plan without having penalties assessed against you. If you pull money out before age 59.5, you will owe income tax on the amount withdrawn + a 10% penalty. The CY2018 maximum annual contribution is $18,500, with an additional $6,000 catch-up contribution allowed for those 50 years and older.
Many employers offer a 401(k) matching contribution, such as a 50% match for the first 6% of your salary. This is “FREE MONEY”, and I always recommend that everyone contribute enough in the 401(k) to get the maximum employer match. Beg, borrow, and find a way to make it happen, and never leave free money on the table if you want to retire at some point in your life! Note that I didn’t say to maximize the full 401(k) contribution immediately, just enough to get the maximum employer match for starters. There are other choices to consider once the free money is in hand. More on that later.
It is possible to obtain an up-to-5Y loan from your 401(k) from your employer, provided that you are still employed by them. That loan period is longer for purchase of a primary residence. There is a lot of debate in this area, so others who have done this will be able to provide better advice. There are also ways to access your 401(k) earlier (e.g., Rule 72T), but those really should be discussed with an expert.
The Roth Individual Retirement Account (Roth IRA)
The Roth IRA is another retirement vehicle where you put post-tax dollars into the account and the investment growth on those dollars are not taxed upon retirement. Not taxed at all, ever. This is such a good deal that the IRS maximum contribution for CY2018 is $5,500 (+ $1k if you are over age 50). If you are early in your career, the advantage is that your tax rate is likely lower to begin with so your investment growth is compounded.
Because the principle in this account has already been taxed, you can withdraw the principle at any time, for any reason, with zero penalties. This is a huge advantage over the 401(k). You can’t put that principle back once withdrawn, but the Roth IRA is essential a huge safety net that is readily accessible. Additionally, withdrawals from a Roth IRA do not count as income. That doesn’t sound like a particularly big deal, but we will talk later about why it’s very big.
The IRS says they restrict participation in the Roth IRA for high earners, and begins to phase-out the ability to fund a Roth IRA if you have a Modified Adjusted Gross Income (MAGI) up to $133k; but there’s a huge loophole called the Back-Door Roth that was “overlooked”. In my opinion, a “wink wink” deal was cut such that the IRS still allows the highest earners to fund a traditional IRA, and convert it to a Roth IRA. It takes just a few minutes, and will likely be the best few investing minutes of your year. Every few years you hear rumblings about the IRS closing the Back-Door Roth, but it’s still open today.
If you haven’t contributed to a Roth IRA yet this year, you still have until the annual tax filing deadline to do so (i.e., 18April2018).
The Heath Savings Account, for high deductible health care plans (HSA)
For those with a high deductible heath plan, a Health Savings Account allows you to put away pre-tax dollars to pay for future health care expenses. It’s the only non-annual mechanism that creates a savings that is never taxed. Cafeteria Plans are annual use-it-or-lose-it accounts, but the HSA has no such annual clearance requirement. Most HSA Accounts also have investment options, so not only is the HSA principle never taxed, but the returns avoid all taxation as well. It’s a very powerful tool, as incurring health expenses at older age is essentially a certainty.
About Expense Ratios
When selecting mutual funds, be careful about funds with high expense ratios. Some of these funds quietly take a full 1% per year (or more) of the total amount in the fund for their management costs. Contrast this with something like a Vanguard Admiral Shares Index fund that takes 0.03% per year, and the savings become massive over a 20+ year period. It’s hard for large funds to beat the street in terms of market returns, so paying extra with no guarantee is a bit of a gamble.
TLDR Version
- Get the Maximum Employer Match from 401(k)
- Strongly Consider Low Expense Ratio Funds
- Establish Health Savings Account (HSA) as part of your Emergency Fund (if applicable)
- Fund Roth IRA to Maximum, using Back Door, if needed
- Fund Health Savings Account to Maximum (if applicable)
- Fully fund remainder of your 401(k)
- Fully Establish your Emergency Fund (i.e., for non-health expenses)
- Roth IRA can serve this function, until a true Emergency Fund is in place
- Set up Living Revocable Trust, Health Care Directive, Power of Attorney, and Pour-Over Will to protect it all
- Revocable Living Trusts: avoid the delay and hassle of probate upon death, capturing your wishes upon your death
- Pour-Over Will: for anything that was missed being put in the trust
- Health Care Directive: granting health care decision-making authority to a trusted person when you are not able
- Power of Attorney granting financial decision-making authority to a trusted person when you are not able
- The best way to access these types of money in retirement, including a mix of social security + 401(k) + Roth IRA that minimizes taxes long term.
