Out here in the real world I typically try to mind my own business. However, I had a good friend make an off-hand comment the other day that I’ve been struggling to forget. He mentioned that he was not maxing out his 401k, but he was maxing out his IRA each year. I had so many questions, but didn’t want to pry. Specifically, determining the most appropriate strategy of where to invest first is often dependent on your level of income, which most of us consider a very private matter. ( I wrote here about the conundrum of how to discuss your journal to financial independence with family and friends). I’m not even sure what kind of IRA to which he is contributing. It’s important for all of us to understand how you can retire faster by optimizing your 401k and IRA contributions.
Perhaps next time I see him I’ll see if he wants to hear my two cents on the topic? And perhaps you would like to hear my two cents? If so, please read on.
First, let me cover a few basics to make sure we’re all on the same page.
What are all these retirement accounts and some of their features1?
- 401k – An account, through your employer, where you may divert a portion of your paycheck for retirement. These contributions reduce your taxable income in the year they are made. You may invest up to $18k in 2019 and there is no level of income that limits that amount. You cannot easily access these funds without paying a penalty until you are age 59½. All withdrawals are treated as ordinary income in the year of withdrawal.
- Traditional IRA – An account, not associated with your employer, where you can contribute up to $6k in 2019. Like a 401k, these contributions grow tax free. There is not an income limit; however, these contributions are only fully tax deductible when your income is below $74k for single tax filers and $123k for married filers. Like a 401k, you cannot easily access these funds prior to age 59½ and withdrawals of pre-tax contributions and earnings are tax as ordinary income (post-tax contributions can be withdrawn without tax implications as long as you are 59½).
- Roth IRA – Similar to a traditional IRA except contributions are never tax deductible. However, the contributions and earnings are not taxed when withdrawn after 59½. Further, contributions can be withdrawn tax free prior to age 59½ as long as the funds had been in the account at least 5 years. The ability to contribute to a Roth IRA is limited by your income. If your Modified Adjusted Gross Income is above $137k ($203k if married) you are not allowed to contribute directly to a Roth IRA2.
Taking full advantage of the tax advantages of these types of accounts is effectively a way to make the government pay you to save your own money.
In a perfect world, we would max out our 401k and IRA’s. But it’s often not a perfect world. It took Mrs. Middle and I several years to slowly build up to where we were maxing out both. So which do you max out first? This seems like it could be a complicated hierarchy, but it’s really not.
Let’s start by covering the two easiest steps in that hierarchy. First, you should always at least contribute enough to your 401(k) to get the full match of your employer (don’t give away free money!). Next, there’s no reason to make non-deductible IRA contributions if you’re not already maxing out your 401(k). Where this question become a little more nuanced is when you’re deciding if you should contribute to a Roth IRA if you are not already maxing out your 401(k).
From a pure mathematical standpoint, there is no material difference from receiving your tax benefit at the time of contribution (401k) or at the time of withdrawal (Roth IRA)3.
Therefore, I would tend to lean towards maxing out your Roth IRA first due to the greater flexibility with regards to withdrawals.
If this is what my buddy is doing, he’s doing exactly what he needs to do to retire early by optimizing his 401k and IRA contributions. However, if he’s contributing to a traditional IRA, he’s sub-optimizing in a big way. Perhaps I’ll ask him the next time I see him…
What has been our personal strategy to retire early by optimizing our IRA and 401k contributions? We’ve been maxing out our 401(k)’s and maxing out our traditional IRA’s. Since we earn too much for our IRA contributions to be tax deductible the only tax advantage is that the earnings grow tax free. We have also typically earned too much to make Roth IRA contributions.
There is a way to recharacterize traditional IRA contributions to a Roth IRA (called a Back-Door Roth); however, there are tax implications of this if you have existing traditional IRAs2.
Doing so while at peak income tax levels would be cost prohibitive. Back-Door Roth’s have enough nuances that I plan to cover those in a future post rather than covering it here.
Disclaimers (as is expected with all of the fringe nuances of optimizing your contributions to your IRA and 401k to retire early)
1These are the general guidelines. On the fringe, there are certain nuances and exceptions to almost all of these rules.
2There are alternative ways to fund a Roth IRA even if your income exceeds these limits. Mrs. Middle and I have executed the “Back-door Roth” process a few times in the past. There’s a lot of tax implication nuances here that makes this process a potential future stand-alone post. The Mad Fientist has posted extensively on these types of more complicated strategies.
3Assuming that you expect your tax rate to be similar at the time of contribution and withdrawal, which may not be a good assumption based on your particular situation.