Which account do I fund first?
From checking & savings to brokerage, 401ks, HSA, and 529s: there are a lot of accounts to choose from! Where should you focus your savings? What is the "right" account to put your money to save on taxes and grow it for the future? Today we discuss the order of account funding, which accounts to focus on first, second, and third.
Listen as we discuss:
- Paying off high-interest debt first
- Saving for Emergencies
- Finding free money (401k match and 529 state-tax deductions)
- Health Savings Accounts (HSA)
- Roth IRA and backdoor Roth contributions
- 457 deferred compensation plans
- SEP IRA, 529s and more
- Traditional vs. Roth IRAs
- Health Savings Account (HSA)
- Marotta on Money: Account Funding Priorities for 2021
Welcome to financial planning for tech entrepreneurs. I'm your host, Mike Morton chartered financial counselor and financial advisor. In today's episode, I'm having a conversation with my good buddy, Matt. All around which accounts to fund in which order. We're all aware of a variety of accounts that we have from savings and checkings and brokerage to 401k's and IRA's and HSA is and 529s.
It gets very confusing. So in this episode, the two of us talk about the order of funding. When you have some extra savings, where should you focus on that savings first? Which accounts should you be targeting and why? This is an episode that was broadcast live on the air with matt so I hope that you enjoy it
Matt: [00:00:55] We frequently feature Mike Morton of Morton Financial Advice who takes us through the world of personal financial planning, investing taxes, savings.
You also give out great advice on various life strategies, life hacks. I guess that's what the kids call it these days, life hacks. Why the heck would you want to hack into your own life? Mike Morton
Mike: [00:01:19] Thanks, Matt. It's great to be here.
Matt: [00:01:21] It's great to have you. I'm excited about today's topic because it's really well-suited for just about anyone who is thinking in any way about saving, investing, retiring someday paying for their kids, or their own education someday.
It's interesting. You and I went to the same college and there's a semi-famous psychologist from that college. His name is Barry Schwartz and he came up with this theory and calls it the paradox of choice. And what it basically says is when there are too many choices, people are a lot less happy.
And I feel like in the world of savings, financial planning, your bailiwick financial advising. There are too many darn choices. , you and I just did a show last week where we talked about just within the world of individual retirement accounts, you rattle off like four or five different names that I think I'd heard of, but you've got 401k 403b.
IRA's in 15 different flavors health savings accounts. So the big question today, and I think this applies to absolutely everyone is: how do you start to think about that? How do you decide where to focus, where to save first? What's your order of operations? So Mike Morton, how do you think about that?
Mike: [00:02:36] Yeah, that's a great topic. And you're exactly right. There are a tremendous number of types of accounts and ways and strategies for doing this. And of course, it's unique to everyone's situation because what you have access to via your work plans and family situation and the state you live in.
And, your background of what careers you're working on really has a tremendous influence on which strategies and topics will make sense for you. So today we're going to give a big overview. Of a potential strategy top to bottom on where to focus on which accounts first, second, third, where you can think about putting some money, but apply this to your situation.
Because some accounts you won't have access to some might not make sense for you, but this is a great sort of top to bottom of account funding. Which accounts to fund first, second, third. And also, I think you're going to find some surprises in here. It's not just, saving the employer account and then saving your brokerage account.
There's lots of other, like little things in here.
Matt: [00:03:40] Got it. Got it. All right. Let's
Mike: [00:03:42] All right. Let's start. Let's dive in.
Matt: [00:03:44] Yeah. First things first. All right. So I have a little extra money. I want to save it. Where do I start?
Mike: [00:03:50] All right. First things first, if you have any high interest debt. Credit cards, right? I'm thinking about you guys: credit cards, 10, 15, 20% interest rates. That's what we're paying off first. And I'm not talking about your mortgage or student loans or anything with low interest rates. . In fact, we might not even mention them again.
We might not I get there, they're all the way at the bottom. That's last. Okay. But first right off the top, anything with high interest, we're going to pay that down right away. So if you have any of that credit card debt, that's where you're gonna focus
Matt: [00:04:21] Is there a rule of thumb these days for high interest? Like at what level do you start to say, Ooh, this is high.
Mike: [00:04:26] It's a hard one, but I would say anything above six to 10%. Yeah. And you're not really gonna, there are two ends of the spectrum, right? Credit card debt and other debt. That's, 10, 15, 20%. And then student loans and mortgages are now 3%. You're not going to find a lot in the middle it's commercial loans and other stuff where that's what you have access to.
Matt: [00:04:44] Got it. Got
Mike: [00:04:45] Yup. And then the next thing, and this will be surprising. So let's say, okay, good. Got rid of that credit card debt. We don't have that. , the next thing I would look at is 529 plans. Education plans, not for saving for the future, but running current expenses through a 529.
And what I mean here is that if you have kids in college today and they have expenses, okay, I got to pay a tuition bill of $10,000. You might get a state deduction for running the $10,000 through your 529 plan. Basically put it in and then immediately take it out and make that payment. You can get state tax deductions for 529 contributions.
Now the lovely state of New Hampshire, no state taxes. So this is no help. Okay.
Matt: [00:05:33] First time people have said that. Oh no, no
Mike: [00:05:35] Yeah.
Matt: [00:05:36] no, this is what this is super clever. Wow. You're right. This is counter intuitive to so I've got a kid in college or whatever, and I've got a 529 account. It is perfectly legal and above board. If I've got expenses routed through the 529, and in many States, I may get
Mike: [00:05:52] In fact, let me take the state of Virginia. , if you run $10,000 through that five to nine, you can get almost $500 of savings depending on your tax situation. So there's 500 bucks for, a few clicks, right? Running it through there.
Matt: [00:06:05] Wow. That is awesome. That is a hot tip. All right. Okay. All right. So now we've taken the we've taken the hot tip. Now I've I've got a little more money, let's say w what do I do
Mike: [00:06:14] Yeah. So if you want to save it, emergency funds will always be next. In order wants you to build up some emergency savings now where to do that. There's different places you can, but the first is just look at your savings or checking. This money needs to be accessible? So about typical three to six months of expenses.
So look at your expenses depending on your job, how stable it is or how risky it is of losing a job. That's what the emergency savings are for one of the major reasons. So you want to build up that emergency savings. There are other places that you can look to do that within an account. And we'll talk about some of those other accounts first.
I'd just say, just save it that's the important thing have the money. Then you can look at maybe putting it in a Roth IRA because you can take money back out. Contributions to a Roth can be taken out tax free after five years. So you want to start that Roth account early, get that five-year window taken up and then 6,000 a year or 7,000.
If you're over 50. You can take that money that whose contributions back out. So Roth IRA could be a place for saving it or an HSA. And we'll talk about both of those coming up, but emergency funds, make sure you have accessible money. About three to six months worth of expenses. ready to go
Matt: [00:07:21] Okay. Okay. And I'll put in a quick plug here. If people are interested in the topic of Roth IRA's, we've done actually two shows on that topic. One about traditional versus Roth, IRAs, the other on doing a backdoor conversion. They're both really helpful guides, especially for someone like me who didn't know a lot about those topics beforehand.
. All right, we've gone through step one. Step two. What's next.
Mike: [00:07:45] You know, We haven't even talked about retirement savings, right? It was just where people usually start. So that's where we're going. Next. The employer retirement accounts. This could be your 401k or 403b, but not maxing it out. Just putting in the percent that you might get a match from your employer. So they might match 3%. The first 3% you put in, or they might match 50% of the first 6% that you put in. So whatever that matches that you're getting free money, we will take advantage of that free money. So put in that 3%, that 5% or 6% definitely take advantage of getting their contributions.
Now this might be, yeah. And I was just going to say, this might be either a traditional or Roth option. Within the retirement account. And so again, you can look back at those other episodes to see what, which one might make sense for you. But my rule of thumb is if you're young, look at the Roth option because you're probably in a lower tax bracket.
And so that's a good way of going Roth deferrals are just amazing. It's more of a recent tool. So definitely look at that. The employer contributions will always be in the traditional side. And so again, if you put your contributions on the Roth side, tax-free, then you'll have some in both, which is always good to have multiple tools in the toolkit.
Matt: [00:09:04] makes sense. All right, so I'm gonna, I'm gonna just hit pause On the order of operations and read this back to you at a high level. What I'm hearing is first rule is if you're in a hole, stop digging. So if you're in a hole with high interest debt credit card debt, stop the digging by cutting out that debt.
So you've got an available. Little pile of cash, let little pile of cash. Stop digging. That's number one second rule is make sure that you're not going to end up back in the same hole next time. That's the emergency savings part. The third rule here, and this seems to apply to both the.
The that tricky 529 thing. And also this employer matches look for free money.
Mike: [00:09:49] Look for free money.
Matt: [00:09:50] if you can get free money, either through routing expenses through the 529 or by saying, Hey, my employer will give me money. That is mine. If I simply save those sound like good options.
Mike: [00:10:02] That's it, Matt you got it. Exactly. No, that's a good
Matt: [00:10:05] roles. Those are good rules by the way. These are good general rules. When you're in a hole, stop digging. Make sure you don't end up back in the same hole and look for free money. Fantastic. Yeah.
Mike: [00:10:14] That's it. Even when you're walking down the street, look for free money.
Matt: [00:10:17] Look for free money it's the Homer Simpson principle. Ooh, free goo. If they're offering, you might as well take it. You did make one point there though about the employer match contributions to an IRA. I'm sorry, to a 401k, which is, you're not suggesting totally maxing out in that direction.
You're saying max out to the extent that you're getting free money.
Mike: [00:10:41] Yep. That's right, because there are other places that I would say are more important to save more money, to save money than continuing to just maxing out the 401k or the 403b those retirement plans. So just get the free money go that far to the, to the match. And then we'll have some other recommendations.
We'll get back to maxing that out soon, but there's some other places that we would save money first.
Matt: [00:11:06] Got it. So if it's 3%, 3%, if they match 5% match, 5%. All right, then you stop there. So now you've. You've worked your way through this. Keep using order of operations. That's like a geeky math term. I got to stop that. All right. So you've worked your way through the game of chutes and ladders, right?
I don't know.
Mike: [00:11:23] Whatever.
Matt: [00:11:24] on this next step. All right. Step four.
What did we do next?
Mike: [00:11:28] A health savings account with the next place that I look at the HSA and I'm a massive fan of HSA health savings accounts. So we've had a whole podcast episode about these accounts as well, because it's the only account that has triple tax benefits, no taxes when the money is contributed. No tax as the money compounds or stays invested.
And then when you withdraw it, you still don't pay taxes as long as it's for a qualified medical expense and is the only account that has that. And that's why I'm such a fan of it. Now, of course, there are limitations. You do need to have high deductible health plan in order to have an HSA along with it.
And so it may not apply to everybody's situation, but if you do have access, that's the next place that I'm looking to save money. Now, of course you can run money through this and use it for current health expenses and you still get that tax deduction, but you can also save that money for the future.
Invest it, allow it to compound and grow and then use it down the road. So you can save receipts from your current year's health expenses and pay yourself back in the future once it's allowed to compound. But you can also use it as a deferred tax vehicle, just like your 401k or individual retirement account after the age of 65.
You can withdraw money penalty free for any reason. Now you'll still pay taxes on it, just like that 401k accounts traditional or traditional IRA, but you can use it as that type of account. Once you're past age of 65, or you can, of course always use it for medical expenses and pay for that. Tax-free.
Matt: [00:13:05] And I would just direct listener's attention to your comment about the time machine. It's like a hot tub time machine of savings with you can save receipts in the health savings account and let your money compound, and then. It magically you get this benefit in the future check out that episode about health savings accounts, because that was another one of these sneaky little tricks that I thought was really cool.
Okay. So that's step four. Now,
Mike: [00:13:33] we got more to go.
Matt: [00:13:35] even more money?
Mike: [00:13:36] Yeah. And again, some, and some of these don't apply, so you can skip right over some of these, and we're not.
Matt: [00:13:41] You can't do step four. So you look to step five.
Mike: [00:13:44] A lot of people are, haven't even put that much. It'll just that they've done the match. So there's a few thousand bucks, right? Because they've already got the emergency savings and stuff. So the next place, and I do have another little tip here. This is the next one's going to be the Roth IRA or a backdoor Roth IRA.
And we've done an episode on the back door and how that works. But the Roth IRA is just an amazing account. I'm a big fan of the tax-free forever. Situation. Most people do not have enough money in those types of accounts, the Roth tax-free accounts. So I'm really big fan of using those. And here's a tip on this one, even if you haven't gotten to that point yet that you've got your emergency savings.
Go on, you're paying down your credit card, open up a Roth IRA account and just put in $1. All right. Get the account open and just contribute a dollar. The reason why is that? There's a five-year rule. On the Roth IRA. After it's been open for five years, you can withdraw your contributions for any reason.
Tax-free because you've already paid taxes on the contributions. Okay. So you put in $6,000, you have to pay taxes on the 6,000, but you can take it back out. Tax-free . After five years. So get the account opened early, just put in a dollar, keep it open. And so that way you start that five-year rule because of the Roth IRA.
And we'll get to this. See, I haven't mentioned 529 accounts are saving for college because the Roth IRA can be a really great option for it. Pay for education costs. It's for retirement first, but if you need to, you can always take those contributions back out, tax free penalty
Matt: [00:15:12] See, I thought when you mentioned $1 that you had a bet going with Randolph and mortar Berg Duke, but that is a really awesome tip. . I love these little on the internet, they call it weird tricks. I get the feeling. Yeah. You just referred to other accounts.
Let's get into that. Just before we, because we've already gotten in so many, like tips here. So there are a lot of accounts so what other options are there?
Mike: [00:15:35] so now we're back to, at this point, you can fully fund those retirement accounts back to the 401k. The 403b those retirement accounts are, if we've saved, , gotten your match, we've gotten the HSA funded. We've gotten your IRAs individual retirement accounts funded. Now go back and fully max out those other accounts. Now. What else is there? All right, there are still more types of accounts at this point. There's a 457 deferred compensation plan. Some people have access to this government plans, some nonprofits. The 457 is different from a 401k or 403b. Those have shared income limits, , shared contribution limits, 19,500.
Okay. For the employee. The employer can put in some money on top of that, the 457 is totally auxiliary plan that you can also put in another 19,500 into a deferred compensation plan. And sometimes these even have a Roth option. . Traditional versus Roth, we've already talked all about it.
So sometimes they have that option as well, and it's deferred compensation. So you put in money and then , compounds hopefully, and then you get that paid back. So at this point, We've maxed out our 401k, our HSA. Our IRAs now our 457. I You're over $50,000 of retirement savings at this point.
And you're doing a great job.
Matt: [00:17:01] That's that's a lot. That's a lot. Oh, wow. Okay. All right. So if your head isn't already spinning what else do we have? That's just part of the menu.
Mike: [00:17:11] There's another, yeah, the after-tax contributions to 401ks is something I run across quite a bit. That employer plans will allow you to do after tax contribution. So you've mapped again, you have 19,500 that you can do as part of your salary. And then a lot of plans say if we haven't hit the limits for the overall plan, the employer can put in.
Money as well. So you put in 19 five, you can do up to that. The employer can put in money as well. The total is about 57, 58,000 between employee and employer. So those working in small, self-employed places, whatever, always trying to max out that 58,000, get it all tax deferred. But if you're working at a large organization, they put in some money that match, that up to 5% you can put in more contributions.
Of your own money it's after tax. And then a lot of them have in plan Roth conversions. So again, I'm not going to get into details of all that because it gets pretty fuzzy. I can see people's eyes starting to gloss over already on the other side of the radio, but it is an amazing vehicle for again, getting more money tax-free forever.
Matt: [00:18:20] Definitely something to check out. If you think it's like the Jeff Foxworthy routine, you might be in this situation.
something, something to check out. Now you're making me nervous here because we've gotten all this way and you talk right at the top about your trick about using 529.
If you've got a kid in caught under a very specific
circumstance, but you haven't talked generally about 529 yet. Why are we so far into this without getting into 529? So are they not, they shouldn't be any earlier in the sequence.
Mike: [00:18:51] , not really. And the reason there's a few reasons people will lend you money for education, but no one's lending you money for your own retirement. That's the big reason that you want to focus on your own retirement first. The other thing is that we've mentioned the word Roth many times here and the Roth IRA , was very high up the list and that money can be used for funding education.
So I always recommend looking at that first. Now there's certainly a lot of my clients and a lot of situations that the kids' education is really important. It's one of their top three values. And if that's true,529 are great, they are, tax-free put in the contributions, use them for higher education.
Fantastic. So I definitely recommend that if it's one of your higher values, but in terms of just order of operations for funding accounts, I would always look at your own retirement first and making sure that's funded again, many of these accounts you can use for education purposes. That's what comes down to the other thing is.
You can always take out loans for your kids' education. You can take them out if it comes to that, and then you can use your retirement funds to pay back those loans over time. So again, the retirement accounts can be used for education. It just, you're going to spend it, over time. And that's where the 529 come later down the process, again, depending on your personal values and unique situation.
Matt: [00:20:12] Got it. All right. I imagine the answer to this is yes, there's a lot of stuff we haven't covered because there's so much stuff out there, but quick highlight. What's the number one thing we haven't covered that you want to make sure to get in.
Mike: [00:20:23] I would say SEP IRAs. We didn't mention that a lot of people have them look at contributing step IRAs, but then doing immediately doing Roth conversions of your SEP IRA. So you can look into that further, but that's a good place to go. And then at the high level things that we have mentioned, but it just reiterate systematic Roth conversions in general, and taking advantage of those tax free accounts.
And I'm we go back to the very top, pay down debt, make sure that your high interest rate stuff is getting paid off. First, low interest rate all the way down here at the bottom.
Matt: [00:20:57] If you're in a hole, stop digging. Make sure you don't fall in any other holes and look for free money wherever you can get it rules to live by from Mike Morton of Morton Financial Advice. Thanks so much for running through all of this. I'm going to go check out where by where my money is. Maybe I've it all wrong.
Thanks so much.
Mike: [00:21:16] You bet.
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