If you’re lucky enough to work for one of the many tech companies that offer multiple ways to save, you may be wondering which programs to prioritize. For instance, Microsoft employees have the good fortune of having access to a pre-tax/Roth 401(k), after-tax 401(k), ESPP and HSA. If you can afford to maximize them all, well that’s fantastic. They all offer their own unique advantages. But if you can only afford to save to one or two of the above, how do you decide? Which is most important? Which one makes the most sense for you?
You will undoubtedly get sick of me saying this, but like most things in your financial life, it depends. What I’ll offer here is some general advice, but it will likely vary depending on your unique circumstances.
An overview on the options:
401(k) – either pre-tax or Roth
In 2023, you can save up to $22,500 to a pre-tax or Roth 401(k). If you’re over 50, you can save an additional $7,500, called a catch-up contribution. I typically recommend you at least take full advantage of your employer match. That may or may not mean deferring the full annual contribution. In the case of Microsoft, they match 50% of your total contribution (up to the annual limit). If you defer the maximum amount, they will match $11,250. That’s HUGE. On top of your salary, bonus, and RSUs, you’re getting another $11,250 from Microsoft. This is a no-brainer (assuming you can afford to save $22,500 per year). Whether you save those dollars pre-tax or Roth is highly individual; I suggest you work with your financial advisor to determine what makes the most sense for you.
OK, so you’re saving $22,500 per year and you still have “extra” cash- what’s next?
I’m a big fan of Health Savings Accounts (HSAs). That’s a blog post for another day, but in short, an HSA offers incredible tax benefits that you cannot get from any other account type. You can contribute to an HSA on a pre-tax basis, the earnings grow tax-free AND all withdrawals are tax-free. That’s a pretty incredible combination.
In order to contribute to an HSA you must be enrolled in a High Deductible Health Plan (HDHP). If you are, you can contribute up to $7,750 for a family and $3,850 for an individual in 2023 to the HSA. Unlike a 401(k), that total actually includes the employer contribution. Again, we are talking free money here! Microsoft will contribute up to $2,500 to a family account or $1,000 for an individual (in 2022).
If you still have room for extra savings:
In addition to the pre-tax or Roth 401(k), some companies, like Microsoft, also offer the after-tax 401(k), also known as a Mega BackDoor Roth 401(k). With this option (and continuing the Microsoft example), once you have maxed out your 401(k), plus Microsoft’s $11,250 match, you have the option to defer another $32,250 to an after-tax 401(k). (The total IRS annual limit for all contributions in 2023 is $66,000.)
There are a lot of great things about a Mega BackDoor Roth, not least of which is that if you’re very high income, you don’t have that many savings options that are tax-advantaged. This allows you to save aggressively into an account that won’t be taxed in the future. Note: it’s important to make sure your after-tax contributions are automatically being converted to Roth.
Employee Stock Purchase Plan (ESPP)
Finally, at Microsoft you can save to an Employee Stock Purchase plan (ESPP). The federal limit for an ESPP is $25,000 of the un-discounted stock, which with a 15% discount means you can save $21,250. I’ve also written about the specifics of Apple’s ESPP plan here. There are some definite benefits, though the tax implications can be complicated and you have to manage the selling and reinvesting process. It may still be worth doing, but generally lower on my list of savings options.
If you happen to make enough money to save $22,500 to your 401(k), plus $7,750 to an HSA, plus $32,250 to your after-tax 401(k), plus $21,250 to an ESPP, by all means!
For many people, that’s just not realistic and they must prioritize. Broadly speaking, my order or preference is:
- Pre-tax or Roth 401(k)
- After-tax 401(k)
As mentioned above, this may not be the best order for your situation. For instance, if you plan to retire very early (say, age 50), you might not want to tie up too much in a 401(k) and would rather save to a taxable account. In that case, maximizing the ESPP (then selling and diversifying out of company stock) would make more sense than filling up the 401(k) buckets.
It’s a highly individual decision, but this framework applies in many situations. As always, I encourage you to work with your financial advisors to decide what’s best for you.