When it comes to saving for retirement, there are many options to choose from. But what is the best order to save in? Should you prioritize your 401(k) or an IRA? Should you consider contributing to taxable accounts? What if you have debt, does that change the calculus?
It can be difficult to determine the best way to save for retirement, especially since everyone’s situation is different. But to simplify things, here is the workflow that I use when working with clients who are saving for retirement.
1. Get the Company Match from Your Employer’s Company Retirement Program
If your employer provides you with matching contributions to a retirement plan, such as a 401(k) or 403(b), contributing to these accounts should be your first priority. In this first step, invest enough to earn the full amount of the company match, but no more. We will return to these accounts later.
Why? The reason is simple: A match is effectively free money. You can earn a 100% return on your investment. Nowhere else can you get a 100% guaranteed return with no risk.
2. Contribute to a Health Savings Account (HSA)
If you currently have a high-deductible health insurance plan, you may be eligible to contribute to a Health Savings Account (HSA).
HSAs are great because the money you contribute to these accounts is tax-deductible, the money grows tax-deferred, and withdrawals from these accounts for qualifying medical expenses are tax-free.
If you’re eligible to contribute to an HSA, make sure you’re contributing the maximum amount each year. You can then invest your HSA funds, let them grow, and take money out of the account for qualified medical expenses. I explain this strategy in much more detail here.
3. Contribute to a Roth IRA or a Traditional IRA
Once you’ve maxed out your HSA contributions, the next priority is to contribute to a Roth IRA or a Traditional IRA.
The contribution limit for both types of accounts is $6000 for 2022 ($7000 if you’re 50 or older).
If you’re eligible to contribute to a Roth IRA, that’s usually the better choice.
With a Roth IRA, you contribute money that has already been taxed, so your withdrawals in retirement are tax-free.
With a Traditional IRA, you get an up-front tax deduction for your contributions, but withdrawals in retirement are taxed as ordinary income.
4. Contribute to Your Company Retirement Plan
If you’re not already doing so, the next priority is to max out your company retirement plan.
For 2020, the 401(k) contribution limit is $19500 ($26000 if you’re 50 or older).
The 403(b) contribution limit is $19500 ($26000 if you’re 50 or older).
The catch-up contribution limit for both 401(k)s and 403(b)s is $6000.
So if you’re 50 or older, you can contribute up to $25000 to a 401(k) or 403(b) in 2020.
If your company offers a Roth 401(k), that’s usually the better choice (but not always).
With a Roth 401(k), you contribute money that has already been taxed, so your withdrawals in retirement are tax-free.
With a Traditional 401(k), you get an up-front tax deduction for your contributions, but withdrawals in retirement are taxed as ordinary income.
You can learn more about the differences between Roth and Traditional 401(k)s here.
5. Contribute to Traditional IRA with Nondeductible Contributions
After you’ve maxed out your company retirement plan contributions, you can still contribute to a Traditional IRA.
If you’re not eligible to deduct your Traditional IRA contributions, you can still make nondeductible contributions.
With nondeductible Traditional IRA contributions, you don’t get an up-front tax deduction, but you will enjoy the benefit of tax-deferred compound growth.
6. Contribute to Taxable Accounts
Once you’ve maxed out your contributions to a company retirement plan and/or IRA accounts, the final step is to invest in a taxable account.
While you’ve exhausted the best tax-advantaged options, you can always invest in a taxable account. There is no limit to the amount of money that you can invest in these types of accounts. It is critical, however, to be aware of the tax efficiency of your investments. There are a variety of ways to increase your tax efficiency, including asset location strategies, tax-loss harvesting, and others.
The bottom line is that there’s no “right” answer when it comes to the order in which you should save for retirement. The best way to approach this decision is to consider all of your options and make the best choice for your unique circumstances.