Roth IRAs and 401(k)-Type Plans

For longer-term goals like financial independence and retirement, you’ve got to be all in on tax-advantaged accounts like Roth IRAs, 401(k)s, 403(b)s, 401(a)s, 457s, the TSP, and others.

These accounts are hands down the best places to save and invest. All else being equal, they’ll yield a higher after-tax return than a regular taxable brokerage account. Saving and investing for longer periods amplify your advantages.

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Higher Contribution Limits

401(k)-type plans allow you to contribute considerably more tax-advantaged dollars per year than other accounts. If you’re trying to reach financial independence sooner rather than later, or you’re approaching retirement and are a bit behind, the higher 401k contribution limits are a godsend. They’re over three times the IRA contribution limits.

Some employers offer a company match, which is the greatest wealth-builder of all. If you’re offered one, do whatever is necessary to receive all of it every year.

Traditional vs Roth

Most employer plans offer both traditional and Roth options. Don’t overlook Roth contributions. What’s not to like about tax-free earnings for life? Traditional vs Roth will help you come up with your perfect contribution: All Roth, all traditional, or a double dip, which is my personal favorite, especially for higher-wage earners.

If you’re not offered a retirement plan at work or you want to utilize both, turn to IRAs. Unlike 401(k)-type plans, where commingling is encouraged, with IRAs you’ve got to “keep ’em separated”: Roth contributions (Roth IRA) and traditional contributions (Traditional IRA) must be directed into separate accounts.

Investment Options

What about your investment options in 401(k)-type plans? I’ve found some employers go to great lengths to offer only the best plan for their employees. Others, not so much. Find out whether you’ve got what I call a dog plan and meet my 17-year-old mutt, Rosie.

After-Tax Contributions

Some 401(k)-type plans offer after-tax contributions in addition to regular contributions. After-tax contributions are inferior to regular traditional and Roth contributions but enable tax-advantaged contributions in excess of the 401(k) Limits.

Certain 401(k)-type plans also allow conversion of after-tax contributions to Roth, either recharacterized within the 401(k)-type plan or moved to a Roth IRA.

This maneuver, called a mega-backdoor Roth conversion, can involve big numbers (thus the “mega” adjective). See how mega in my after-tax contribution example. For you super-savers out there striving for financial independence, there’s no better and faster way to get there!

Non-Deductible Contributions

Of course, not everyone is lucky enough to be offered a 401(k)-type plan. Even if you’re over the Roth IRA income limits, don’t fret. A backdoor Roth IRA conversion is much like the mega version, except it’s done exclusively with IRAs instead of a 401(k)-type plan (and involves smaller numbers). One other difference: Uncle Sam calls those extra contributions non-deductible contributions instead of after-tax contributions, even though they’re basically the same thing.

When I heard about these opportunities over a decade ago, I thought it was too good to be true; however, both conversions are perfectly legal and approved by the IRS and Uncle Sam (at least for now). They’ll help you reach your financial goals faster than you ever thought possible.

Tax-Advantaged Alternatives

If your 401(k)-type plan doesn’t offer those options, or your employer doesn’t offer any plan at all, no need to worry. You’ve got lots of alternatives:

If you’re under the Roth IRA income limits, you can invest directly in a Roth IRA.
If you’re over the Roth IRA income limits, you can execute a backdoor Roth IRA conversion.
You can invest in a traditional IRA; However, if you or your spouse are covered by an employer retirement plan, another set of income limits applies for traditional IRA contributions.
If you check all the boxes, you can use a Health Savings Account to save and invest.

Becoming Financially Independent

These strategies are not the next new get-rich-quick scheme, app, or gimmick. They will, however, build your wealth faster regardless of your accepted amount of risk, be that super-aggressive, super-conservative, or somewhere in between. And they’re designed to maximize your returns no matter what your stage in life: Just getting started, mid-career, approaching retirement, or already retired.