With a task as important as funding your retirement, determining which accounts to fund and in what order should not be taken lightly. Whether it’s a company plan, individual retirement account or taxable account, there are a lot of ways to save for retirement. So how do you decide where to put each dollar you plan to save? Of course, it depends on your circumstances, but let’s look at some general guidelines that might help with your retirement-savings decisions.
Bucket #1 – Save up to the match in your 401k/403b. Not saving enough to meet the employer’s matching contribution is one of the biggest mistakes Americans make when it comes to retirement savings. If you have a 401k or 403b at work that offers a match, this should be the first place you stash away your savings. Failing to meet the company match is essentially like missing out on free money.
Bucket #1A – Max out your Roth options. It is important to determine if your company’s plan has a Roth 401k option. With the Roth version, you make contributions with after-tax dollars, meaning there’s no tax deduction; however, the IRS permits distributions to be tax-free once you’ve had the account for five years and have reached age 59½ (assuming the employer’s plan document allows distributions while still employed or the person is retired). Also, with a Roth 401k, there are no income limits on eligibility to contribute unlike a Roth IRA. In 2018, the max contribution to a Roth 401k for those younger than 50 is $18,500, and for those over 50 it is $24,500. If your company doesn’t offer the Roth 401k option, we suggest contributing enough to get the match in your traditional 401k and then, if eligible, contributing to a Roth IRA.
Bucket #2 – Max out your traditional 401k. Once you have met the match in your 401k and maxed out your Roth options, the next step is to defer enough of your income to hit the maximum contribution limit in your traditional 401k. Like the Roth 401k, the max contribution for 2018 is $18,500 for those under 50, and $24,500 for those 50 and older.
Bucket #3 – Max out your HSA. If you are covered by a high-deductible insurance plan that meets certain requirements, or if your employer offers this type of plan, you should be able to contribute to a Health Savings Account. An HSA is a highly underutilized account with many tax advantages that can be a great compliment to your 401k or IRA. The annual contribution limit in 2018 for taxpayers with family coverage under an HDHP is $6,900. An HSA is one of the most tax efficient ways to invest- if the funds are invested for retirement and used for retirement healthcare expenses, this is the only type of investment that allows a tax deductible contribution and a tax free withdrawal.
Bucket #4 – Save in a standard taxable account. Once you’ve filled all these other retirement buckets, the next best step is to save and invest in a taxable account. There are no deductions or tax-deferral on these accounts, but you will enjoy capital gains tax rates (top rate of 20% vs. ordinary income top rate of 39.6%) when assets are sold for a gain. The key here is to get the money invested so it will hopefully grow over time and protect against inflation.
By breaking your retirement savings into different buckets, particularly different tax buckets, you will provide yourself much greater flexibility when you actually need to start drawing funds out.
And last but not least, before you get too focused on the order of operations, don’t forget priority #1 – make sure you are saving enough money! Our rule of thumb is to save at least 15% of earnings for retirement.