Retirement Account Order of Operations

The decision to put money into the correct “wrapper” in order to maximize “tax alpha” is more important than which stock, mutual fund, index, etc… you invest in. Think of “wrappers” as places where your money exists (as digits in a computer database)… that have certain rules. We collectively make up the rules to this game through Congress and the tax system.  Just like when we were kids, we came up with rules to games like “The Floor is Lava”. In our adult lives, we do so with money via the tax code and Congress… with just as much emotion (if not more). Knowing these adult rules (or having access to people who do) will reveal obvious right answers. So, here’s the correct order of operations (FOR MOST of us):

  1. Maximize any company retirement plan matching: it’s free money, you can’t beat it. Anyone telling you otherwise is trying to sell you something. If you’re debating “Bitcoin” vs “401K match”… I’m not your person.  Maximizing the company matching contribution is the best “wrapper” for your retirement funds.
  2. After maximizing company matching funds, IF your “Modified Adjusted Gross Income” (MAGI) is less than $65K per year, money should go with a “wrapper” called a TRADITIONAL IRA.  A traditional IRA allows you to not pay taxes now… and pay taxes later when you withdraw funds later during retirement.
    1. You should LOWER YOUR TAXES NOW, because only about 0.1% of people have a higher tax bill in retirement than during working years… and about 80% of retirees pay an effective tax rate of ZERO.
    2. The tax deduction for the traditional IRA phases out if your income exceeds $65K per year!
    3. MAGI = your adjusted gross income minus business / rental losses.  You can ignore MAGI in most cases if you do not own rental properties or are part of a business… or have a few other rarer situations.
    4. Adjusted Gross Income is your gross income minus some tax deductions such as student loan interest, self employment expenses, and some one rare one-off situations: MORE INFO HERE
  3. IF your MAGI exceeds $65K per year, THEN:
    1. Consider maximizing your company retirement plan contributions beyond the company match, IF the fees are reasonable.
    2. Consider the Roth IRA. You make Roth IRA contributions with AFTER TAX money… but you will not be taxed when you withdraw funds later during retirement.
    3. The Roth IRA is available to anyone making less than $140K per year (i.e. MAGI less than 140K, higher if married).
    4. But almost everyone has a lower tax rate in retirement then during their working years.  The tax benefit is less valuable for a Roth than a Traditional IRA, but it is still a very nice tax benefit (you can think of “wrappers” like video game “power ups” if that helps… The Roth IRA not the best “wrapper / power up”, but still really good).
  4. IF your MAGI exceeds $140K per year:
    1. Maximize your company retirement plan contributions
    2. Use the Traditional IRA.  You will receive NO tax deductions… but you can “backdoor Roth IRA convert” this money as well which is highly recommended. Essentially, you can always access a Roth IRA… you just have to be more “paperwork literate” to do so.
    3. At this point, CONGRATS! Go ahead and interview “wealth managers” to help you. You are in firmly in that industry’s target customer demographic. Have you considered Veblan Goods?
  5. EMOTIONALLY, some people just prefer Roth IRA / Roth 401K’s.  While statistically, this is a bad idea for most, if it makes you emotionally happier, go for it!

To wrap up, these are the current rules. We have these tax rules because we don’t want this psychological effect to occur: RIGGED MONOPOLY. 2020 was a hell of a year to look back through the prism of our current rules… in our entire tax / spending code.

Good luck to everyone, and remember… it’s all just a game of The Floor is Lava, Cowboys and Indians, or whatever game caught your imagination in your youth.

P.S. If you want your INCOME to be higher for mortgages and loans, you might want to use a ROTH before a traditional retirement vehicle because that will show up in your taxable income, which can help you get a mortgage / loan.

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