Sunday, 3 March 2019 -- A Napkin Guide to Retirement
Death and Taxes
Like all napkins, we need to start with a table. In this case we have the three different types of cash flow for a retirement account. Deposits, Growth, and Withdrawal, and circles indicating whether that type of cash flow is taxed or not. For example, growth in a brokerage account is taxed, so the up arrow has a circle. In a Roth or Traditional retirement account, the growth would not be taxed, so the up arrow has no circle.
| Tax Type | Deposit | Growth | Withdrawl | Traditional |  |
 |
 |
|---|---|---|---|
| Roth |  |
|
 |
| Brokerage | |
 |
|
This table makes the tax advantages of Roth and Traditional accounts versus brokerage accounts obvious. You’re either saving on inflow or outflow taxes, and you’re saving capital gains on growth. Since savings on taxes are money in your pocket, the simple guide says to dump everything in these advantaged accounts.
Unfortunately, the government also likes money so there are limits:
Contribution Limits by Account Type
| Management Type | Contribution Limit ($, 2018) | Allowed Tax advantage types |
|---|---|---|
| Brokerage | N/A | N/A |
| 401k | 18,500 | Traditional, Roth |
| IRA | 5,500 | Traditional, Roth |
| HSA | 3,400 | Traditional1 |
Gotchas
Therefore, you can contribute up to $24,000 into tax advantaged accounts per year (2018). However, there are a few important gotchas regarding which money should go into which accounts.
First, employers who match 401k contributions essentially always match with traditional funds. So if you get, say, a $5,000 match then that $5,000 will show up in the traditional bucket of your 401k.
Second, high income earners (above $120,000/year for single earners) begin to get ‘phased out’ of Roth IRA contributions. Above $135,000 they can’t contribute at all. There is a loophole, the “backdoor Roth”, which involves making a traditional IRA contribution and converting it to Roth. However, if you already have a large traditional IRA balance, this backdoor gets closed. Therefore, if you think you will make above $120,000 in your careers, traditional IRA contributions are discouraged.
Third, while the individual contribution limit to a 401k is $18,500 per year, the maximum annual contribution is $54,000. So, for example, an employer match contributes to the 54k limit but not the 18.5k limit. This leaves most contributors with a large amount of the 54k limit left over. In some 401k plans there is a system for taking advantage of this leftover limit, called an “after-tax (non-Roth)” contribution. This is also known as a “mega backdoor Roth.” To use it, again assuming your 401k plan allows it, you make after-tax contributions up to the remainder of the 54k limit. That money is then converted into Roth, which effectively makes it a Roth contribution without counting toward the 18.5k limit. Note the ability to do this is dependent upon the particular details of a 401k plan, and any growth on the after-tax contributions are considered traditional.
Finally, traditional accounts are subject to Required Minimum Distributions (RMDs). These are government-mandated withdrawals of some percentage of the account balance after age 70. Ensure you consider this extra income (and the tax liability that comes along with it) in your retirement planning. Consider converting some traditional money to Roth prior to 70 to better manage tax rates in retirement.
These notes come from a conversation about retirement accounts with a coworker over lunch, via a napkin.
HSA contributions are tax free, growth on the gains are tax free, and qualified medical expenses can be spent tax free. That gives HSA money spent on qualified medical expenses the rare privilege of having completely tax free cash flow. If you’re interested in min-maxing your tax liability throughout retirement, don’t forget to max the HSA and save receipts for your medical expenses until you need tax free withdrawals.
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