Financial Independence – Step by Step Guide on Contributing to Retirement Accounts

Welcome!  So, you want to gain financial independence but don’t know where to start investing your money.

A question you might have includes:

Which retirement account should I contribute to first?

What should I do with this money that I have saved up?  Roth vs. Traditional vs. Taxable?

The amount of information out there can be daunting so I thought I would put together a simple introduction.

(Standard disclaimer: This is my opinion. Consult a financial advisor to discuss your specific scenario.)

Look closely at your budget and decide how much you can cut back to fund your investments. Common wisdom is to pay yourself first. This means put money into savings or investments before it sits in your checking account and you spend it on something. Live on your reduced budget for a month or two and see if you can cut back even more. You might surprise yourself with how much you can save.  The easiest way to do this and that worked very well for us is to have the amount pulled in pre-tax accounts.

Figure out what your tax rate is.  Here is the 2018 Withholding Tables now available from the IRS

Once you know how much you can invest, plan how to do it. Some investments can be made with a payroll deduction, and some are made using the money in your accounts.


Step 1: Pre-Tax Paycheck deduction –  HSA – Self-only $3,450 or Family $6,900

If you have a High Deductible health care plan with a Health Savings Account available to you, you should work on contributing to this account first.  I suggest putting in some money and then continue to Step 2.  The goal is to MAX out the HSA.   This will lower your Modified Adjusted Gross Income (MAGI).

Thanks to Madfientist research he calls this the Ultimate Retirement Account.  The reason is, it doesn’t take FICA taxes out.  It is truly tax free.   Most employers also contribute to this account.    The max in 2018 is Self-only: $3,450 Family: $6,900.   This amount includes what your employer contributes too.  You can use this account for health related costs at anytime even years from now so keep your receipts.

How to do it?  This is taken out of your pay check automatically.  Talk to your employer to set it up.

Step 2: Pre-Tax Paycheck deduction – Contribute up to company’s match – 401k, 401(a), 403(b), 457(b), TSP

Fund 401k, 401(a), 403(b), 457(b), TSP, or other pre-tax account up to your company’s match.  Find out what the matched amount is and do that.    This is free money because your employer is automatically contributing when they match what you put in.    The goal here is to MAX this account.  Again, it will lower your MAGI.

How to do it? This is taken out of your paycheck automatically so talk to your employer to set it up.

If you are NOT covered by a pre-tax account like a 401k-type account at work, go to Step 5, then you can contribute to a Traditional deductible IRA.

Step 3:  ROTH IRA – Personal account (after-tax money) $5,500 – Skip if your income is to high 

Fund a Roth IRA next, if you are below the standard deduction. Here is a calculator to help you. 

Roth IRA is an after tax retirement account that allows you to contribute up to $5,500, in 2018.  It will grow tax free and will never be taxed because you already paid taxes on it. (Unless the law changes.)  It is a huge advantage if you are already in a lower income tax bracket because you aren’t paying many taxes so it is best to save up in a ROTH while your taxes are low.  There are no penalties on withdrawals of Roth IRA contributions. There’s a 10% federal penalty tax on withdrawals of earnings.

When you are in the higher income tax bracket it makes sense to do Step 4 next because the pre-tax account lowers your MAGI.

The ROTH does have an income limit based on your MAGI.

How to do it?  You will have to create an account to start a Roth IRA.  I highly recommend create one at Vanguard.

Step 4: MAX Pre-Tax Accounts – Up to $18,500 and HSA see Step 1

Finish funding the 401k-type plan to the max.  This is helpful because it lowers your income (MAGI).  For those with higher incomes, this can be funded instead of the Roth IRA.   This is taken out of your pay check automatically.  The max you can contribute in 2018 is $18,500 for 401k and 403b.  If you are married, and both have pre-tax accounts with an employer you can both contribute up to $18,500 each.  If you haven’t already Max out the HSA account in Step 1.

Step 5:  Traditional Deductible IRA – Personal account (after-tax money that you can deduct on your taxes) – Skip if you did Step 3  – $5,500 Max 

After you MAX out your 401k-type account fund a Traditional (deductible) IRA , you can also do a traditional deductible IRA, if your MAGI qualifies see the chart at the IRS.

If you are NOT covered by a pre-tax account like a 401k-type account at work, then you can contribute to a Traditional deductible IRA.  See the chart at the IRS.

Note: You can contribute to both a Roth and Traditional IRA but combined you can only contribute MAX $5,500 in 2018. More information about IRAs can be found here at the IRS.

How to do it?  You will have to create a Traditional IRA.  I recommend create a Traditional IRA at Vanguard.

Step 6:  Traditional Deductible IRA – If your Spouse doesn’t work or doesn’t have a Pre-Tax Retirement account – $5,500 MAX

If your spouse doesn’t work you can contribute $5,500 to their traditional IRA this is called a spousal IRA.  I recommend create a Traditional IRA at Vanguard.   This isn’t a joint account or a special IRA it is just a Traditional IRA in the spouse’s name.   More information at Vanguard about spousal IRA.  This is something a lot of families miss out on so don’t miss out.

How to do it?  You will have to create a Traditional IRA in your spouse’s name.  I recommend create a Traditional IRA at Vanguard.


Step 7: Personal Taxable Investment Account – after tax money 

I suggest funding a taxable account with any money left.  This money you can use at anytime and can be what you live off immediately when you are considering Financial Independence.   Most bloggers in the Financial Independence community will agree you will need at least 5 years of living expenses while waiting to do Traditional IRA to Roth conversions the waiting period is 5 years after you convert from a Traditional IRA to the Roth.  Investing is the best way to make that money grow faster.

How to do it?  You will have to create a taxable brokerage account and I recommend creating it at Vanguard.

Additional Information and answers to questions I had:

I make more then the low tax bracket for the Roth that you mentioned but make more then the Traditional (deductible) IRA, what should I do?   Should I contribute to a Roth since I still qualify?

As long as you have MAXed out ALL of your pre-tax accounts then you have 3 options:

1. Yes, you can contribute to a Roth.   It is a great way to save.   Note:  It is already taxed money and will be tax free when you retire.    You can take out the contributions of a Roth out at anytime.  A lot of bloggers talk about this.

2.  Contribute to a taxable account Step 7.  I highly recommend doing this option.   As a lot of bloggers point out the taxable account needs to be looked at because there is no limit how much you can contribute or how much is taken out.  You will get taxed on dividends and when you sell.  Most of the time, you will let it sit and grow.  The big point is you will need at least 5 years of expenses to live on while you are doing Roth conversions (see below) and having a taxable account is the best place to keep it.

3.  Do both 1 and 2!   The more you save the sooner you will be financially independent.

What is the amount of income that you can receive that is so low that you will pay little or no taxes?

It does depend on your deductions.  In 2018, the standard deduction has increased so most people will not itemize but you still will have “above the line” deductions and credits.   There is a very good tax calculator that can help you figure this out.   The more you put in the 401k pre tax account, the lower your adjusted income and thus the lower your taxes will be.

What are Roth Conversions?

Roth Conversions is simply converting money from a Traditional IRA to a Roth IRA.   You will pay income tax on the amount you convert.  More information about Roth Conversions can be found here at Vanguard.   Check out Madfientist  article – How to Access Retirement Funds Early.

For more details I highly recommend reading:

The Simple Path to Wealth by JL Collins – Stock Series

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books. Big Profits) Hardcover by John C. Bogle

The Bogleheads’ Guide to Retirement Planning by Taylor Larimore,‎ Mel Lindauer,‎ Richard A. Ferri,‎ Laura F. Dogu

The Bogleheads’ Guide to Investing by Taylor Larimore,‎ Mel Lindauer,‎ and Michael LeBoeuf

Traditional IRA vs. Roth IRA – Madfientist

Note: These are my opinions. I’m not a tax professional or financial advisor.  Do this at your own risk.

I hope this answers some of your questions just like the ones I had.

Happy Savings!   Holly