This post was inspired by multiple residents asking questions everyone expects you to know but no one ever explains such as “What is an IRA vs a 401k/403b” or “What is the difference between a Traditional or a Roth retirement account?”
There is no one right way to invest your money, but below is the path taken by many people from what is advocated in the White Coat Investor to the majority of users on personal finance forums such as Reddit. Obligatory disclaimer: I am not a financial advisor and not responsible for any losses incurred.
Summative flowchart of the process, updated with figures from 2021 at the bottom
Step 1: Make sure you have an adequate emergency fund and are able to pay the bills (rent, food, transportation, utilities, health insurance, minimum debt payments, & anything required to keep you earning an income)
Step 2: After establishing an emergency fund, make sure you contribute enough to your company 401k/403b to maximize your employer match. This means your employer contributes a certain amount to your retirement savings plan based on the amount of your own annual contribution. Typically, employers match a percentage of employee contributions, up to a certain portion of the total salary.
Assume your employer offers a 50% match on all your contributions each year, up to 4% of your annual income. If you earn $100,000, the maximum amount your employer would contribute each year is $4000. To maximize this benefit and get the “free $4000,” you must contribute $8000.
Not taking advantage of an employer match is the equivalent of leaving "free money" on the table
There is often a vesting period, meaning the employer match money isn’t yours until you have been at the company for an x amount of years and you may forfeit some or all of it if you leave early. The money you contribute is not in jeopardy if you leave early.
There is no employer match for residents at this institution. There is a match for attendings.
What is a 401k? A 401k is a retirement savings plan offered by most employers that has tax advantages. A 403b is the equivalent in a nonprofit institution. There are two basic types of 401ks; traditional and Roth
In a traditional 401k, employee contributions are "pre-tax." That is, the money is deducted from gross income and no taxes are due on it until the money is withdrawn. With a Roth, employees pay the income taxes up front but can make withdrawals tax-free
Now all this money can grow in a tax-free or tax-deferred index fund (the S&P has averaged 7.5% growth a year over the last 20 years)
It is usually advantageous for residents to invest in a Roth retirement account since their tax rate will be the lowest in their lifetime. It is usually advantageous for attendings to invest in a traditional retirement account since their tax rate is likely the highest in their lifetime
At this institution, residents only have access to a traditional 403b.
Step 3: After maximizing your contributions up to the employer match, you should pay off any high interest debt (10% or greater). For lower interest debt, sometimes it is more advantageous investing the money you would have used to pay off the debt.
The S&P-500 has an average annual growth rate of 8% over the last 20 years and the Nasdaq-100 14.2% over the last 20 years. Plus there are dividends paid out that further increase growth. $10,000 put into the S&P in 2000 would be $32,200 in 2020.
Some people find it more personally liberating and better for psychological wellbeing to pay off debts, especially moderate interest debt around 5% (excluding mortgage). There is only a theoretical possibility that your money might grow 8% in the S&P, but your debt will for sure increase by 5% each year.
Step 4: After paying off your high interest debt, you should maximize your IRA ($6000 is max contribution). An IRA is similar to a 401(k) account that anyone with earned income can open, but is not obtained through the employer. Instead it is through the individual's personal bank or online brokerage. These come in the same flavors, Roth or Traditional.
There are far more investment choices in an IRA, often with lower fees and less rules.
There are income limitations on contributing to a Roth IRA (https://www.investopedia.com/terms/i/ira.asp). But you can still set up a Roth IRA if you make over the contribution limits (125k filing individually, 198k married filing jointly) via a backdoor Roth. https://www.nerdwallet.com/article/investing/backdoor-roth-ira
If you choose a traditional IRA, you can deduct it off your taxable income if your income is below a certain amount (66k for singles, 105k for married couples filing jointly).
Step 5: Maximize your company 401k/403b. You can contribute up to 19,500 in your 401k/403b. All this money can grow tax-deferred or tax-free depending on if it is a traditional or Roth account.
If the employee also benefits from matching contributions from their employer, then the combined contribution from both the employee and the employer is capped at $58,000. No employer will give you $38,500 in matching contributions, but this quirk allows for something known as the mega-backdoor Roth. Most people do not have access to this method or even need to use it, but it is an option for those who feel behind on their retirement savings https://www.nerdwallet.com/article/investing/mega-backdoor-roths-work
Step 6A: Start a Health Savings Account if available and beneficial in your situation. Most people who have high-deductible medical insurance plans have the option of adding an HSA with a maximum contribution of $3650. Employer contributions and the individual’s contributions are excluded from the employee’s taxable income. Unused balances at year-end can be carried forward and earnings in the account from investing in stocks and bonds also are tax-free.
All these similarities to a Roth IRA give it the nickname the “stealth IRA.” It is even more tax advantageous than a Roth IRA because you use pre tax dollars and do not pay taxes on withdrawal for medical expenses.
There are disadvantages include having a high deductible plan & taxation on any non-medical withdrawals (but that is the same as a traditional IRA). https://www.whitecoatinvestor.com/retirement-accounts/the-stealth-ira/
Step 6B: Personal Taxable Investment Account. At this point, you will really have options and financial freedom to take more liberty, risk, and save for immediate goals. This is the final step because you are using post-tax dollars and getting taxed on all the gains, meaning there is no tax advantage at all (and thus is saved till the very end when you have maxed out all your tax-advantage options unless you are saving for more immediate goals - the previously described tax advantage options don’t allow you to touch your money until retirement age - 59.5 or greater).
How should you allocate your account? This question also applies to how you should distribute your IRA, 401k/403b, & HSA. As a general rule, the sooner you need the money, the more bond allocation you should have. The further away you need the money, the more stock allocation you can have (stocks are more volatile, but averaged over decades, have a much higher growth rate and certainty). https://www.investopedia.com/articles/investing/062714/100-minus-your-age-outdated.asp
You will owe taxes on any gains here (along with any traditional 401k/IRA), with the steepest rates on short term holds. https://www.investopedia.com/articles/stocks/11/intro-tax-efficient-investing.asp
Yes, at this point you have permission to buy Bitcoin & Ethereum with your left over money
This may seem daunting at first, but it is not as challenging as one thinks to follow. IMO, it is no more challenging to understand than a failed airway algorithm or Well’s criteria and equally important for us to master.
