Hierarchy of Savings

Every single person should have a clear hierarchy of savings, primarily driven by tax arbitrage (link). On January 1, where do you put your first dollar of savings in the year? What about your second dollar? 10,000th dollar? Etc?

I believe the following list should work for everyone, whether you’re making $10k or $10M per year, or whether you’re worth negative $100k or positive $100M.

  1. Contribute to 401k up to company match.
    1. It’s idiotic to turn down free money.
    2. Think hard about Roth vs Trad 401k decision (if Roth choice is available to you), as a mistake here can cost you hundreds of thousands later in life, though these posts will probably lean you towards Trad (link1, link2).
  2. Get out of any debt > 5%, beginning with highest interest first.
    1. If you’re itemizing, your effective interest rate on mortgage debt is (1-marginal tax rate)*Mortgage Rate.
  3. Max out HSA (& limited purpose FSAs up to what you’ll spend) if offered by your employer.
    1. Pre-tax in and pre-tax out. HSAs are exempt from payroll taxes (6.2% soc sec + 1.45% medicare), which is not the case with retirement accounts, as well as state + federal.
    2. If you can have sufficient cash flow, don’t reimburse yourself immediately (link1, link2).
    3. A “limited purpose” FSA is used for eyeballs and teeth. Google it to learn more.
  4. Max out 403b & 457.
    1. If you work for a public institution like a university.
    2. If you have several kids and moderate income, prioritizing 403b&457 funding above IRA can help you to hack the EITC.
      1. If your 403b & 457 custodian is awful (high fees) and you aren’t trying to hack the EITC, then consider prioritizing IRAs above 403b & 457.
    3. 457 can be withdrawn at any age after severing from company without 10% early withdrawal penalty. 403b can not. However, 403b can be accessed before age 59.5 through Roth Conversion + 5 year seasoning period.
  5. Max out remainder of 401k.
    1. If you have several kids and moderate income, prioritizing 401k funding above IRA can help you to hack the EITC.
      1. If your 401k custodian is awful (i.e. high fees) and you aren’t trying to hack the EITC, then consider prioritizing IRAs above 403b & 457.
      2. 401k can be accessed before age 59.5 through Roth Conversion + 5 year seasoning period.
  6. Max out IRAs.
    1. X 2 if married.
    2. Think hard about Roth vs Trad IRA decision, as a mistake here can cost you hundreds of thousands later in life,  though these posts will probably lean you towards Trad (link1, link2).
    3. Backdoor Roth IRA if your income is too high. Straight Roth if your income is above Trad IRA deductibility limit but below Roth IRA limit. If your income is near the Roth IRA income limit, then do the backdoor to avoid any potential problems arising from unexpectedly high income,
    4. If you want the ability to withdraw principal from a Roth IRA early for emergency funds or use a Roth IRA for a first time home purchase, consider prioritizing IRA above 403b & 457 & 401k.
    5. If you qualify for the Saver’s Credit, consider prioritizing IRA higher to ensure full receipt of the credit.
  7. Think hard about making after-tax contributions to a 401k.
    1. After capping out your $18k contributions to a 401k, think hard about making after-tax contributions to a 401k, especially if your company allows for in-service distributions. At first glance this might seem counter-intuitive. The point of the 401k is to get a tax benefit now because it will be taxed on the back end later. However, after-tax contributions can set you up for a lucrative Mega-Backdoor Roth (http://www.madfientist.com/after-tax-contributions/, https://www.whitecoatinvestor.com/the-mega-backdoor-roth-ira/).
    2. One of my big financial regrets is not exploiting this while working for 4 years at MegaCorp, which allowed for after-tax contributions to a 401k and in-service distributions. But this was years before I became aware of the strategy.
  8. Contribute to 529 up to state deduction limit if you have kids and care to assist with college.
  9. Taxable brokerage OR 529 over state deduction limit OR prepay mortgage.
    1. I can’t really think of a good reason to prioritize any of these three above the others.
      1. However, reader Dave below indicates that prepaying the mortgage is a great way of hacking the FAFSA to appear poorer for financial aid while paying for college, since the FAFSA (myopically) neglects home equity.

We’ve roughly adhered to the above list of priorities roughly our entire life, though only recently have we had the cash flow to get past number 5 above. I can’t think of a good reason why anyone would deviate from the above.


**** Edit 2/12/21 ****

I created a corollary post to discuss the optimal sequencing of retirement withdrawals (link). Perhaps the above suggestions will make more sense in light of this follow-on post.

46 thoughts on “Hierarchy of Savings”

  1. This is a great list! I’d add that even if your effective mortgage rate is below 5%, from a college aid perspective, you might be better off increasing your home equity than your taxable investments. (That is, unless your AGI is high enough that you have zero shot at any need-based financial aid for your children.) For schools that use the FAFSA form, home equity isn’t counted at all, though it can be a consideration for colleges that use the CSS form.

    • Thanks David! That’s a really good point.

      It’s amazing how many tax hacks are available once you live frugally enough to generate savings and put a few minutes of thought on how to allocate your savings across accounts. FAFSA hacking is definitely something I will become better versed in as my kids approach college age (oldest is currently 10 so still a few years off for me).

  2. It’s not that far off — our older kid just started 7th grade, but we’ll be using our 2021 tax return to apply for aid for her freshman year (2023-2024)! I’ve only started looking into aid strategies, but with no real foresight on my part, we’re fairly well positioned for FAFSA aid from an asset perspective, as most of our assets are in tax-deferred retirement accounts and home equity, both of which are shielded. Income, of course, is the other factor, and I was somewhat shocked to see that the effective family contribution includes a fairly high percentage of your AGI. And the “marginal rate” is even higher — for each additional dollar in AGI, we’d be expected to contribute 31 cents of it toward college costs. Combined with federal and state tax rates, that will push our total marginal rate into 70% territory for the years our children will be in college. It’s actually inspiring me to attempt to retire (or at least semi-retire) by the end of 2020.

    • I had forgotten about the lookback period for the FAFSA forms and the fact that you have to plan years in advance if you care to strategize around the FAFSA.

      One things for sure, the entire system (tax, financial aid, healthcare, etc) rewards low income. And that’s precisely the income scenario of an early retiree.

      You’ve certainly given me some food for thought on prioritizing the repayment of my mortgage sooner than later. I still remain convinced that a little bit of money in a taxable account is okay to aid in tax loss harvesting, but I guess I’m unsure how big I’ll let this pot grow before I start aggressively paying down the mortgage.

  3. I’ll tread carefully here, as I don’t want to come across as the relatively well-off guy whining about college costs. Overall, I have no problem with colleges giving more aid to lower-income families. However, what bugs me somewhat is that for any two families of equal income, the system rewards the one that hasn’t saved for college (or accumulated other assets) in the form of higher need-based aid!

    There’s another quirk that might work in your favor, as you have more kids than me – overlapping years in college. If the FAFSA form determines your effective family contribution is $25k a year, that’s the total, no matter how many kids you have in school in any given year. (With two kids in college, the FAFSA simply divides the total EFC in half for each kid.) That’s understandable, as if you can afford $25k a year from your income stream, you can’t necessarily afford 2X that amount if a second child enters college.

    But it does mean that the total cost of college for families with similar finances and the same number of children will vary greatly, based on the age distribution of those children. For example, a family with twins and an EFC of $25k will end up paying $100k for two college degrees. Yet a family with the same income and assets, but with kids who are four years apart, will spend twice as much for two degrees, paying the $25k EFC for eight years. Our two kids are three years apart, so we’ll only benefit from a single year of college overlap.

  4. Good list! Just a note about trad vs. Roth IRA: if you already have access to the 401k and your income is high enough, you might as well contribute to a Roth IRA instead of traditional because of the loss deduction benefits. For single filers, the deduction phase out starts at a MAGI of $62k and is completely lost at $72k. The 401k phase out is much higher, so most people are fine sticking with traditional 401k’s. (correct me if I’m wrong!)

    • Dylan, you are correct that Roth IRA clearly trumps Trad IRA for those who have high incomes who are either entering or exceeding the deductibility phase out range.

  5. regarding no. 6 maxing out 403b or 457. what if you don’t get any additional funds from your employee on it and they limit who you can invest through? My concern is the fees with the chosen investor are higher then paying the taxes and investing in an IRA on my own.

    • My current employer allows me to save $18k in a 403b and $18k in a 457 per year. The tax savings along on those two accounts is roughly $16.2k/year. If I were over 50, I’d be able to contribute $48k total rather than $36k total.

      In terms of tax arbitrage, this is a no brainer, even in the presence of high cost funds. When you leave your current employer, you can port the investments to Vanguard and pay essentially nothing in fees after the transfer. However, if you pass up on the opportunity to fund either account either year, the opportunity for tax arbitrage is lost forever. See https://frugalprofessor.com/how-to-mint-money-using-tax-arbitrage/

  6. 403b and 457’s should be higher on your listed, no lower than 4. Why, no penalty on withdrawals before 59. Reach your number and retire at any age.

    • Your points are very well taken about 457, as distributions can be withdrawn penalty free before 59.5.

      However, you are incorrect about 403b before 59.5, with the exception of severing from a company at 55. https://www.bogleheads.org/wiki/403(b)#Distributions

      Basic rules regarding distributions from a 403(b) plan include:

      A withdrawal of assets prior to age 59-1/2, will be taxable at income tax rates and will result in the IRS imposing a 10 percent penalty tax (unless certain criteria are met.)[note 3]
      Withdrawals are taxable unless one meets one of the following exclusions:
      Attain age 59-1/2
      Separate from service in or after the year in which you reach age 55

      With that said, 403b and 401k can be accessed early due to Roth Conversion Ladder strategy.

      • Jim, I reshuffled the list a bit and clarified a few things. Thanks for your input. With my marginal tax rate of 45%, I certainly prefer 403b&457 to IRAs because I’m above the TIRA deductibility phaseout.

  7. Good post to help with savings hierarchy. But one thing missing here – which I struggle with – is the relative priority of a fat emergency fund versus tax advantaged savings. I personally err on the side of having too much in retirement but very little cash. And I hope I won’t regret this l. But every time I build up a nice emergency fund I seem to have to do my taxes and the benefits make me raid the emergency fund to max out tax advantaged savings and then I need to spend another 6 months rebuilding the emergency fund. So this is something I personally struggle with getting the balance right on.

    • Dave, thanks for the post. An emergency fund is something I haven’t quite figured out either. I currently have 50k in Roths which I can liquidate in a moments notice in the event of a true emergency that couldn’t be handled with cash on hand + credit cards. But frankly I’d probably prefer liquidating taxable brokerage stocks and pay a small tax penalty to access emergency funds. This would prevent the hemorrhaging of precious Roth accounts, which action cannot be undone.

  8. Thank you for this hierarchy! So helpful! I had no idea about number 7. I believe we are able to this and now I’ll have to check into that today. Also, appreciate the link to MF’s post on that topic!

    • Happy to help. If you could shove an extra $30k/year after tax into a 401k, then convert to a Roth for $0 in extra taxes, your Roth will be massive in a few short years, setting you up perfectly for early retirement.

      • Well, I found out that my husband’s employer allows for the mega backdoor Roth, at least from what I read in his 401k info booklet. So that’s great! But, we are limited to only contributing 40% (or less) of each paycheck towards his 401k, which means we would need to make $120k in order to fully fund the $18k and ~$30k into after-tax… which we don’t, unfortunately! But, at least we will be able to contribute some after-tax $$, just nothing near the full $30k.

        At the end of the sentence on 5.1.1., did you mean to put 401k instead of 403b and 457?

  9. This article really got me thinking. So essentially if you are close to a tax bracket cutoff can you use something like the 403 (b) to bump yourself down there by making contributions?

  10. My state has no income tax, hence no deductibility for a 529 plan for me.
    It seems like Number 9 could add:
    Fund UTMA account for your kids (if you want to help them).
    -Kids with less than 1k of investment income (dividends) don’t have to file a tax return.
    -But, of course this might hurt your kids come FASFA time.
    —–This begs the question, which is best: UTMA or 529? (perhaps Roth is best if you can somehow pay them).
    -529 does not hurt FASFA possibilities, right?

    • Tim, great to hear from you! How’s life?

      Seeing how you live in a state with no income tax, I can definitely understand the logic of not funding 529 plans.

      The first question is whether our kids will qualify for any need-based financial aid in the first place. If not, the whole discussion about the FAFSA is moot. I think it will likely be moot for both of us, but let’s pretend that it’s not.

      This looked informative:
      If your child has $25,000 in savings account, the child will be expected to contribute 20% of the asset ($5,000) each year toward the cost of college under the federal methodology, 25% under the IM ($6,250) and only 5% under the CM ($1,250). If your child owns a 529 college account of Coverdell ESA the aid treatment is more favorable under the federal calculation. The same $25,000 in a 529 account will only be assessed at a maximum of 5.64%, and sometimes it may not be assessed at all.

      So the name of the game for FAFSA hacking is to get as little assets in the name of the child (UGMA/UTMA) with an expected contribution rate of 20% and as much assets into the 529 plan with an expected contribution rate of 5.64%.

      I’ve also read that Roth IRA assets don’t count towards expected contributions:
      Retirement account balances — such as in Roth and traditional IRAs, 401(k)s and 403(b)s — aren’t reported as assets on the Free Application for Federal Student Aid (FAFSA), regardless of whether they’re owned by the student or the parent, says Mark Kantrowitz of Finaid.org. And the CSS Profile, an aid form that many private colleges use, does not factor retirement assets into need analysis, either.

      If I were solely interested in optimizing for the FAFSA, I suppose I’d prioritize the prepayment of mortgage above the funding of taxable brokerage accounts. Further, I’d fund my kids Roth IRAs prior to their 529s. However, they aren’t working yet so I can’t do this yet. I fully intend to do so once they start working though.

      If we revert back to not caring about the FAFSA, I think UGMA/UTMA trumps 529. This post was informative: https://www.bogleheads.org/forum/viewtopic.php?t=135851#p2005687.

  11. Great information! What would you consider high fees? The fees on the index fund in my 401k is .37%, the one in my 457 is .54% and the 403b is .67%. I have no employer match because I have a pension. In this case should I max out the 457 Soni can pull it out without penalty? Also, should I max out the HSA over the 457 even if I’m not getting the full FICA benefit (I don’t contribute to SS taxes)? Thanks!

    • What is your effective marginal tax rate? Family size?

      If I were you, I’d go HSA first. It’s tax free in and tax free out. This is why it’s at the top of my list (after 401k up to company match). To contribute to a HSA you must have an eligible HDHP plan. It’s worth it even if you don’t pay payroll taxes. http://www.madfientist.com/ultimate-retirement-account/.

      The fees that you mention are high. As a result, I’d prioritize IRA contributions above 403b/457, unless you’re hacking the EITC (in which case 403b/457 trumps).

      Even with the somewhat high fees, I’d prioritize 403b/457 before taxable brokerage or prepaying mortgage. Once you leave your firm, you can roll both into a Trad IRA at Vanguard which charges 0.04% for a total US stock market fund.

      If you forgo these 403b/457 contributions, you lose the opportunity forever once Dec 31 passes.

      It’s hard to overstate the tax benefits from thinking strategically about your taxes. It will easily save me many hundreds of thousands of dollars over my life. There are few activities in life that have such a profound return on your time.

  12. Thanks for so clearly articulating your deep knowledge of this stuff. What about folks who are in lower tax brackets long term? Since we are in the 15% bracket and always paying $0 in federal taxes, wouldn’t the math lean towards maxing post tax accounts (Roth IRA and Roth 401k)? Trying to figure out if Roth IRA and Roth 401k is wiser than pretax 401k and TIRA in my situation – 70k annual income, no debt, and 3 kids (stay at home mom). What would be the optimal hierarchy and vehicles (pre tax or post)?

    • The tax code is really complicated.
      Download this sheet to help you: https://frugalprofessor.com/updated-tax-calculator/
      Here’s a good writeup on some subtleties of tax code: https://frugalprofessor.com/etic-guest-post-on-gocurrycracker/

      Assume 3 kids all <= 16. My spreadsheet confirms that your effective federal marginal tax rate is: 31% from 33.5k-53.5k in income and 15% from 53.5k-108k in income. If you dumped $18k into a 401k, it would lower your taxable wages by $18k, bringing you down to $57k in taxable earnings. Doing so would still keep you in 15% bracket. If you work for a public instution (i.e. school teacher, etc) you may have access to 403b/457 which could further reduce your taxable income. If not, you're kind of hosed. So the question you have to ask yourself is whether your tax rate in retirement will be above or below 15%. If you anticipate higher effective rates in the future, choose traditional now. If not, choose Roth now. I'm of the opinion that most normal people like you and me can strategically pay $0 in taxes in retirement. This will be even easier to do if the tax law changes, which doubles the standard deduction. As a result, I think most everyone should be doing traditional IRA/401k contributions. Perhaps the one exception is if you don't have a solid emergency fund then the Roth IRA provides a great option for that. Of course you don't need to do 100% either way. A rational approach might be to do a 50/50 split. Contribute 5.5k/2 to traditional IRA and 5.5k/2 to Roth IRA. This way you're somewhat hedged against future tax increases. Definitely a fun conversation, but at the end of the day it's a gamble on where you think tax rates will go. If you're smart and keep withdrawals below the standard deduction (soon to be $24k), then your effective marginal rate could very well be 0 in retirement. This is what go curry cracker does, despite his very large wealth and close to $100k/year total income (most of which is coming from tax free capital gains and dividends). https://gocurrycracker.com/the-go-curry-cracker-2013-taxes/

  13. I recently finished grad school and started a new job and have been looking around for EXACTLY this sort of prioritization plan – so thank you, because this is tremendously helpful and is the most comprehensive hierarchy I’ve been able to find!

    One question I have: My gross income this year will be ~120k. I can (and plan to) complete the steps 1-5 (although step 4 doesn’t apply to me). In considering steps 6 & 7 – since I make too much for TIRA deductibility, is the best strategy for me to skip step 6 and focus on maxing out step 7 as much as possible? I’ve checked and my retirement plan does offer after-tax contributions up to the federal limit and in-service withdrawals on those contributions.

    Thanks for your input!

    • Happy to help.

      If you make too much for trad IRA, you can do a Roth IRA. If you make too much money for a Roth IRA, you can do a backdoor Roth IRA.

      #6 always dominates #7, no matter what income level you’re at.


      The only remaining thoughts I have is to be very mindful of the new tax law changes and how it impacts your current marginal tax rate. My marginal federal rate dropped from 37.5% to 24%. Whereas it was obvious for me to avoid the 37.5% tax before, it’s less obvious to me now that I shouldn’t lock in the 24% rate now.

      Play around with the 2018 spreadsheet at bottom of page to see your new marginal rate: https://frugalprofessor.com/model-of-new-tax-plan-house-senate-compromise/

  14. I feel like I’m questioning the Bible here, but lately I’ve been thinking a little more about the placement of #2. I’m a huge fan of using interest rate to decide whether to pay off debt quickly. Debt at >5% is like a guaranteed >5% return on investment, so it makes sense to to do this before investing. However, putting money into tax-deferred accounts is like an instant and guaranteed return on investment at your marginal tax rate in addition to the returns of the underlying investment. So if we assume a marginal tax rate of 22% and a conservative 4% return on investment, wouldn’t the tipping point really be debt with interest >26%??? Would love to get your input on this–thanks!

    • Oh ye of little faith! The blasphemy!

      Assume you have a 6% student loan outstanding. By paying off that student loan debt, you achieve a 6% return that is: 1.) risk free and 2.) tax-free.

      Putting $1 to pay off your student loan will, with certainty, reduce your interest burden by $0.06/year until the loan is paid off. This helps to accelerate the date at which the loan is paid off. Even though you’re $0.06/year better off, the IRS isn’t coming after you for taxes on the $0.06/year. Why? Because they can’t tax what you save in interest!

      Relative to investing in the stock market, this produces a certain 6% return per year, with zero risk. Given the high rate of return relative to the risk free rate today and given the zero risk, it seems like a no brainer to me.

      That said, I understand where you’re coming from. However, you have to remember that a $1 contribution to your 401k results in $1*(today’s federal marginal rate + today’s state marginal rate) in tax savings today, but remember that this money will eventually be taxed at your future marginal tax rates. If you play the arbitrage cards right, as I’m planning on doing (and hopefully you as well), then hopefully the future marginal tax rate will be close to zero. But there is no guarantee that this will happen. It’s certainly not the 26% arbitrage that you propose in your comment, though it certainly could be if the tax laws remain stable over time….

      If you have the discipline to save like crazy to max out the tax-advantaged accounts (particularly the pre-tax accounts for the long-term 0% tax arbitrage play), then I think your comment has a lot of merit, particularly if tax law in the future is similar to what it is today.

      Would I rather have A.) $0 in investments and $0 in student loans or B.) $100k in investments and $100k in student loans at 6%? Both of these scenarios have net worths of zero. If the investments in B are post-tax (i.e. Roth), then I’d prefer B. If the investments in B are pre-tax, I’d prefer A. Given that student loans are paid with after-tax dollars, a more fair comparison is scenario B. So yes, I’d rather have $100k in student loans with $100k in Roth balances. However, I have the cash flow and assets to deal with the risk. If I were without work for a year or two it wouldn’t be a big deal to continue to service the $100k in student debt. For many others, this isn’t the case. Further bolstering my support of B is the limited space you can put into Roth accounts every year (or any tax-advantaged account, for that matter).

      So there you go, me blatantly contradicting myself. But I’m currently in a position of constrained tax-advantaged space having maxed out all tax-advantaged space around mid-year. For many others, this won’t be a binding constraint. In such circumstances, I’d recommend going with the zero debt approach for piece of mind.

      Sorry for the incoherent rant to a really good question.

      • Let me take another stab at this:

        Take a 30% (federal + state) marginal tax rate today.

        What you are asking is whether it’s better to take $1 of pre-tax income, and turn it into:

        * $0.70 of student loan repayment (after applying 30% MTR), or
        * $1.00 of traditional IRA/401k/etc.

        It’s not really an apples to apples comparison because the trad IRA/401k is pre-tax while the student loan is post-tax. If today we convert the $1 of trad IRA/401k to a Roth IRA/401k, we’d have $0.7 in Roth IRA afterwards. I would be indifferent towards $0.70 less student loans vs $0.70 in roth today, with the exception of the “limited space” argument made in prior comment.

        That said, if you can pull off the long-term 0% tax rate arbitrage in the future though a traditional IRA/401k contribution today, as I think is possible, I’d prefer the $1 in trad IRA/401k rather than the $0.70 less student loans for reasons you mention. However, this comes with many more risks: 1.) stock market risk (mitigated over very long holding period), 2.) tax law risk, 3.) cash flow risk from inability to pay student loans if bad things happen (i.e. unemployment).

        If you don’t mind these risks, I think $1 to Trad IRA/401k is smart vs $0.70 in student loan. However, you have to realize that it’s not the pure risk-free arbitrage that you initially proposed.

        • To your second comment: yes, this option does involve a little more risk. Especially if there’s a significant chance of unemployment that would last long enough to wipe out an emergency fund. So I’m sure it depends on the person and situation. For someone with decent income and job security, perhaps in a household with two earners, then I feel like the Trad IRA/401k contribution is clearly the better choice. Obviously that’s not the situation that a lot of people are in.

          Anyway, thanks for chatting! Just saw your ebike question–to be honest I haven’t gotten to ride it in a few weeks due to travelling/pretty crappy weather. But the few times I’ve taken it on the 11-miles-each-way trip to church it’s been great, especially when the weather is nice. I think it’ll very very slowly end up being a good investment.

      • Hahaha! I sincerely ask for forgiveness.

        But I will keep going. Look, Professor, a wise man once said that “a frugal lifestyle is the ultimate hedge against tax rate increases”. This may be naive and/or a bit stupid, but I pretty much assume the 0% (or otherwise very low) future marginal tax rate for situations like this. Yes, tax laws can change and so can life plans, but there are really so many ways to avoid paying unnecessarily high taxes in “retirement”. Also, “earnings” in both cases are tax free, so that’s a wash. And I also assume that the reader has great financial discipline–they are here after all!

        Perhaps the 26% was a bit extreme, but I’ll maintain it’s likely much higher than 5 or 6…

        The A vs B scenario was a bit confusing, I think because what we’re really talking about is a process over time. For example, starting out with 0 assets and 100k of debt and over a period of time going to either no debt and no tax-deferred assets vs putting in the same amount of money (minus minimum payments on debt, plus tax savings) into tax-deferred accounts. I’m saying that the later will result in a higher net worth with minimal future tax consequences (not enough to make it not worth it, anyway).

        Now I’m rambling and I hope those words made at least some sense.

        I’m not saying the Bible should be re-written, but maybe verse 2 needs a little asterisk or something? You know, so it doesn’t slow people down ;).

  15. Can you update this list to include a Roth 401k? My employer offers both and I’m maxing the trad and trying to decide if I should juice up the Roth 401K or pay off my house faster. I’m leaning towards my house in case I get axed or laid off etc.

  16. Great post. Questioning on the Roth seasoning period. I know the Roth account needs to be open 5 years before you can withdraw from it, but does the 5-year rule also apply to each of the annual Roth conversions below the standard deduction level? For example, if my account has been open 5 years and I make a conversion this year, is that conversion immediately available? Thanks

    • Each conversion has to be seasoned for 5 years (unless you’re in your 60s and can withdraw from a retirement plan without penalty). If you do this year after year, this what’s known as the “Roth conversion ladder” which you can google to learn more about.

  17. One may want to mention the excellence of I-bonds at this point, for savings. Soon to be paying 7+ percent, with no risk! Thanks for all the tips!

  18. Im curious to understand how do you fit big purchases in your investment framework. Eg. upgrading house, buying new car or kids’ education? Is that funded from taxable brokerage accounts or somewhere else?
    The reason i ask is that i have 2 big purchases planned ahead and im not clear on a tax efficient way to save and invest money for the phase.
    A lot of this advice is for retirement

    • Good question.

      Since grad school, I haven’t had many big purchases aside from our first (our current) house. At the time we bought our house post-grad school, we liquidated our Roth IRAs (or $80k of them) to fund the down payment. Why did we do it? Because 100% of our wealth was in Roths at that point. I was somewhat reluctant to do so, but we needed the cash.

      If I had to cover a $100k expense today, a good chunk of it would come from my taxable brokerage account. I have a lot of high cost-basis tax lots in there (thanks to 2022), so I could get a lot of liquidity for very little tax cost. I personally wouldn’t touch my Roth now given that our financial situation has changed (i.e. we have viable non-Roth assets), but for others it could provide some nice tax-free liquidity (with the obvious downside of forgone tax-free Roth earnings).

      If it were for a short-term need like a car purchase, I’d consider a HELOC or even a margin loan, then pay it off ASAP with cash flow. Or simply take a conventional car loan for a few months and pay off with cash flow. Or you could do a 401k loan.

      Lots of options available, but the lowest hanging fruit to me seems to be taxable brokerage to the extent that the tax penalty is smallish.

  19. Hey Prof
    Is your strategy to redeem high cost basis units? It could be suboptimal in certain scenarios. For example, assuming you have been consistently investing the same amount, youd have more units when index was cheaper. If the belief is the market will come down, it is more profitable to actually redeem the cheaper units today and then redeem the more expensive ones later

    • By “units” are we talking about real estate?

      The only real estate I’ve ever owned in my life was my current home at the age of 34.

      But I understand the mechanics of what you’re talking about, since it’s the same with “tax lots” of index funds I purchase. If I want liquidity today, redeeming the highest cost basis lots first minimizes realized gains, and thus capital gains taxes. At the extreme, this is what tax loss harvesting is all about — only selling “tax lots” with losses.

      I don’t have anything against real estate investing, but I don’t have personal experience in the area. I’ve seen millions made by friends (last several years), and millions lost (2008). One can certainly make a boatload of money, and the tax code seems pretty favorable to RE investors. A good friend who just moved away was probably worth ~$10M. I observed him utilize 1031 exchanges brilliantly to defer cap gains taxes (seemingly indefinitely). Granted, he had the huge bull market to juice his returns. I also saw him have to evict tenants.


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