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Which Retirement Accounts Should I Use? The Order of Investing

By Jimmy Turner, MD
The Physician Philosopher

You may notice the main image for today’s post.  It is a free-flowing waterfall.  Look at how the water completely covers the first set of steps at the top, before it spills over to cover the next step.  And the next step.  Until finally it reaches the bottom. 

The correct order to fill up our retirement accounts each year should follow a similar pattern.  We should fill up one retirement account until it is full, and then move on to the next.  And then the next until we have reached our annual savings goal.  This is the order of investing, sometimes referred to as Waterfall Investing.

This post is meant to help you determine the order in which you should fill up your investment accounts.  Before we can do that, though, you need to go back and first determine how much money you need to be saving each year. 

Physician Contract Reviews

 

If you do not know your annual savings goal, then click here to read a post on determining how much money to save each year.

Waterfall Investing Basics

The order in which you should fill your retirement accounts until you get to your annual savings number should have a method to it. Typically, I prefer to fill up tax-advantaged space first that is most readily accessible and then move towards the less tax-advantaged space with each step.

One caveat to this is that if you are planning to FIRE (Financial Independence Retire Early) well before the age of 59.5, then you won’t be able to easily access many of your tax-advantaged retirement accounts.  While there are ways around the early retirement gap, it might change how you invest your money.

For example, you might prefer to put a higher proportion of your money into a 457 or a taxable/brokerage account.  Both of these can be accessed in early retirement and/or when you separate from your employer. 

A 401K or 403B will likely be placed into a rollover IRA after you leave your employer, and will be hit with the 10% penalty if taken out before age 59 and a half.

Further Reading: Should I invest in my 457 and everything else you need to know about it.

The Traditional Order

Everyone has access to different plans.  For this reason, I’ve tried to include everything that a typical doctor has access to for retirement.  If something is left off of this list, leave it in the comments and I’ll put it into the list.

Four quick comments before we get to the list:

First, all of the information below ignores your debt.  Readers will know that I am an avid-believer in paying off debt.  [You can read here about how I paid off $200,000 in student loans in 19 months].  In fact, I’ve previously chosen to pay off debt over maxing out my Backdoor Roth IRA for the year.  If you have credit card debt or other high-interest debt, please consider paying that off immediately after Step 1 (get the 401K match).

Second, the order in which this list operates is from most tax-advantaged to least tax-advantaged.  The assumption being that most people reading this post will be in their peak earning years during the accumulation phase. As you approach retirement (the distribution phase) your investment choices may look different.

Third, if you are married, you should duplicate each step if your spouse has access to the same type of account.  For example, you should max out both of your 401K’s before proceeding to the next step.

Fourth, the maximum contributions to retirement plans below do not include “catch up” contributions.  Individuals who are over the age of 50 can contribute more money (usually $6,500 more for 401K/403B/457 plans).

The Order Of Investing for Retirement: Waterfall Investing

Here are the first several steps in your Waterfall Investing Plan. You’ll note that all of the ones listed below offer a tax advantage.

To some extent – depending on your retirement plans – the order of these accounts may be flip-flopped a bit.

1.  The 401K or 403B

A 401K or 403B (hereafter referred to as “401K” to make it easier to read) is the first place your money typically should go.  The reason is that employer’s often offer a match.  Any money not placed into this vehicle (up to the match) is money lost that could have been invested. 

This is the reason I think you should invest at least to the match, even if you are swimming in student loan debt.

Some plans have the choice to invest pre-tax or Roth.  In your peak earnings years, it is traditionally recommended to take advantage of the pre-tax offering in order to decrease your tax burden.

The maximum that can be placed by the employee into a 401K is $19,500.  It can receive matching or contribution money from the employer up to $58,000.

Once you have placed your annual maximum into your 401K/403B,  it is time to move onto the next step with our flow of money.

Note: If you have credit card debt or all-consuming student loan debt… you should probably work on paying that off before proceeding to the next steps.  

2.  Governmental 457 Plans

The second step in waterfall investing involves putting money into a governmental 457 plan. I would argue that you should prefer to place your money into a governmental 457 before your 401K/403B if the 401K does not offer a match. 

The reason for this is that 457 money can be utilized when you retire regardless of your age.

Note this is a governmental 457 plan we are talking about.  Not a non-governmental 457 plan.  Read this post on 457’s if you don’t know the difference. 

The maximum that you can place into a 457 plan is also $19,500. And, yes, you can max out both your 401K and your 457.  That’s not a problem (you can NOT max out both a 401K and a 403B, on the other hand).

3.  Max Out Your Health Savings Account (HSA)

The HSA plan is the only triple-tax free plan that exists (some call it the Stealth IRA).  You place pre-tax money into the account.  It grows tax-free.  And, so long as it is used for medical expenses, it never gets taxed when pulled out.

Honestly, it is the best investment plan that exists so long as it offers low-cost index funds.  However, you shouldn’t choose an HSA plan just for the retirement benefits, if the actual insurance plan offered through it doesn’t best suit your family’s need.

If the HSA does work well for you and your family, you can shelter up to $7,100 for families ($3,600 for individuals).  And, it may never get taxed again!

4. Cash Balance Plans

Some practices offer cash balance plans, which are another way to shelter pre-tax money.  I will not pretend to be an expert on this kind of plan.  They can get complicated, and the rules are different for every partner depending on age.

From what I understand, most plans do not last a long time, and it is more advantageous to have one when you are older in your career than younger.

The amount of money you can place into this kind of account depends on age.  Word on the street is that, for most doctors, $10,000 to $100,000 can be placed into this account (pre-tax) annually.

Of course, make sure the plan is right for you.  If your administrator is investing in high expense ratio actively managed funds, you should probably put your money elsewhere.

Here are some posts for further reading on cash balance plans.

5.  Backdoor Roth IRA

If you still haven’t reached your annual savings number (or don’t have some of the accounts listed above available to you), then the backdoor Roth IRA is the next step.

This is sheltered differently than the accounts listed above. This account offers post-tax benefits.  The money contributed has already been taxed. 

However, unlike a regular taxable/brokerage account, the contribution and the capital gains will not be taxed again.

This is often the last account you’ll touch in retirement.  Roth money is also the best way to give money to your heirs because of the Stretch Roth IRA.

Further Reading: Step by Step Tutorial for First Backdoor Roth IRA on Vanguard

6.  Non-Governmental 457 Plans

Non-governmental 457 plans (NG 457s) are not as straight forward as governmental plans. I’ve dedicated a whole post to this topic, and I’ve linked to it above in this post.

The reason it is so much lower on this list is that it is not really “your” money. It is your employer’s until you get paid the money back after you separate employment or retire.

However, it is investment money that is contributed pre-tax.  It will decrease your overall tax burden. And, so, if you have a good NG-457 plan then you should probably invest in this account before you start doing things that are not tax-advantaged.

This account has a max of $19,500 annual contribution.

 7.  Taxable Accounts

This is the big pool at the bottom of the investment savings ladder.  Once you have filled up all of the space available to you mentioned above, then the rest of your money goes in here until you reach or exceed your annual savings goals.

These accounts can be opened at any of the major investment companies (vanguard, fidelity, Charles Schwab, etc).

A Case Study Example

Say, that you have determined that you want to be saving $125,000 each year.  What do you have available to you? 

Well, if you max out your 401K your employer will contribute/match up to $45,000.  You also have an HSA and NG-457 plan available.  Your spouse works, and he has access to a governmental 457.

For the sake of the example below, let’s assume that the NG-457 plan is a good plan worth investing in for retirement.

So, following the order above we would do the following:

  • Contribute $19,500 to 401K + match/contribution from employer (chosen by employer) = $45,000
  • Max out governmental 457 = $19,500
  • Contribute max to HSA for family = $7,100
  • For each spouse, max out backdoor Roth IRA money = $6,000 x 2 = $12,000
  • Max out non-governmental 457= $19,500

Up to this point, we have saved $103,100. But our goal is $125,000 annually. So, we would then place the remaining $21,900 each year into a taxable account to get to our goal.

Take Home

The take home here is to invest intentionally. The order you should invest for retirement should make sense and follow a logical order.

First, determine your annual savings goals. Then, fill up the buckets in order.

And don’t forget your other financial goals, too!  This post does not include conversations on when you should pay off your student loans or invest for your kid’s college.

What do you think about the order of investing for your retirement?  Is there anything you do differently?  Leave a comment below.

TPP

10 Comments

  1. Xrayvsn

    This is a good framework for how money should be assigned for retirement savings.

    Sometimes it may be beneficial to do partial contributions to something higher on the chain and fill in the next step. For example if your 401k doesn’t have great investing choices, it might be smart just to contribute to meet the full match criteria by the employee, then put money into my next favorite vehicle, the HSA for the triple tax benefits you mentioned.

    Reply
    • ThePhysicianPhilosopher

      Absolutely. There are certainly some nuances to this. The HSA is a great investment plan. Unfortunately, it may or may not be linked to the best insurance plan. I feel like we may have invested in the HSA this year at the expense of our insurance plan and it may come out in the wash in terms of whether more money coming home post-tax (and invested) would have been a better deal.

      Everyone’s situation is different! Thanks for the comment,Xray!

      Reply
  2. Psy-FI MD

    Great job TPP! You’ve crystallized the basics of prioritization of investing buckets. I would personally put the cash balance plan under the HSA and backdoor Roth IRA. From my (basic) understanding, once you start investing in the cash balance plan, you are locked in for the year. If the market dips, you will have to contribute more to make up for the windfall.

    Regards,
    Psy-FI MD

    Reply
    • ThePhysicianPhilosopher

      Definitely worth considering Psy-FI! If ordered strictly in terms of tax advantages, I think the HSA obviously wins out (triple-tax free nature, and all). The cash balance plan does allow for a ton of tax-savings, though people should certainly do their due-diligence before taking part! The point you make should be enough to make many pause.

      TPP

      Reply
  3. HighPlainsMD

    TPP,

    I would be interested to know where on this you would place paying down on a mortgage? You mention where you feel paying down on student loans fit on the list, where does mortgage debt go in your opinion?

    HP

    Reply
    • ThePhysicianPhilosopher

      HighplainsMD, that is a great question. I was actually having the conversation at dinner. When it comes to some debt, you don’t have a choice but to pay it off (like student loan debt, credit card debt, etc) because it will follow you around until you do. Other debt (mortgages are a good example), you can shed easily if you had to by moving and selling the house.

      That said, I don’t like the idea of carrying a mortgage if it has a high interest rate (lets say 5% or higher). And I also don’t like the idea of keeping a mortgage rate around going into retirement or the financially independent stages of your life.

      This is a personal decision, and either one seems reasonable to me (i.e. putting extra money towards the mortgage versus into a taxabel/brokerage account). I guess for me, I’d like to see someone reaching their annual savings goals that will allow them to be financially independent by the age they desire prior to putting extra money towards their mortgage. Once they are reaching that goal, it becomes very reasonable to put extra money towards the mortgage as well.

      TPP

      Reply
  4. Brent Lacey

    Jimmy-
    Having a plan like this that follows simple step-by-step instructions is invaluable. People tend to get “paralysis of the analysis” and plan forever without taking action. This gets them from “ready” and “aim” to “fire” (or FIRE, if you prefer). I personally have used a slightly different order in the last few years based on some different goals, but like you said there are a lot of ways to approach it. Love the simplicity!
    -Brent
    http://www.TheScopeofPractice.com

    Reply
  5. John Misenheimer

    Great post! Thanks so much. My wife started her first attending job and has access to a 403b, 401a, and NG-457b. We plan to contribute to the 403b first and do a backdoor roth for each of us. We aren’t sure what order to fund the 401a though. What order would you recommend placing funding? Thanks in advance!

    Reply
  6. TPM

    I agree, maximizing your before tax investments can really compound your wealth creation and avoid a lot of tax expense, especially after paying off your debts.

    Reply
  7. steveark

    Sage advice, I was able to max out my 401K and Roth or IRA and still able to invest a good bit in taxable brokerage accounts every year of my career. Needless to say I was able to retire slightly early with more than enough invested to allow my wife and I to spend our time the way we want. And we did that without any perceived sacrifice during our earning years. We still got to live the way we wanted because we did not let our lifestyle keep up with our income. Many of my friends are in the same sound financial shape, but regrettably some are not. All because of decisions they made in their early adulthood. I’m glad you are putting good advice out, it can be life changing.

    Reply

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