Planning for retirement was a lot simpler in the past. You’d work for one company for three or four decades, and when you hit retirement age, you’ll get a gold watch for your loyalty and a pension for the rest of your life plus whatever Social Security the government adds on top of that.
Times have changed a lot. Today the idea of working for one company for one’s entire adult life is almost unthinkable. Social Security is expected to be broke by 2035 and will pay out 77 percent of what it promises to pay. Instead of pensions, we have retirement accounts with acronyms that might as well be a bunch of random letters and numbers.
Now that planning and saving for retirement is our responsibility, it is more important than ever that we get it right. With all the different types of retirement accounts, what is the proper way to fund those accounts and in which order is the best to save?
If you are looking for the best way to save the most money for retirement, you need to take advantage of all the different types of accounts that are available. You are leaving money on the table if you only save to only one type of account when you qualify to contribute to several. Unless your earnings are high enough to where you can max out every account, you need to prioritize.
Here is the best order of contributions or optimal order of priority to save for retirement. Use these steps to maximize your tax-free and tax-deferred contributions.
Retirement Accounts Ranked By Order of Contribution Priority
To simplify and optimize saving for retirement, follow this step-by-step guide on which account to start saving to first.
Step 1: Contribute to the 401k up to the Employer Match
The first step you should think about when saving for retirement is if your employer matches your contributions to a 401k (or 403b, 457b, and similar). This is free money and part of your employee benefits compensation package simply for working there.
You will want to deposit up to the full match at the minimum.
Let’s say your employer will match the employee’s entire amount, dollar-for-dollar up to 5% of your salary. You make $50,000 and you contribute the full 5% or $2,500. Your company will chip in $2,500 for their matching portion and your 401k will now have $5,000.
That is an instant, 100% guaranteed return on your investment. No guessing which stocks to pick. No risk of tenants not paying rent like with rental properties. Just the easiest money you will ever make simply for making a deposit into your 401k.
In some cases, you don’t even have to do anything thanks to automatic enrollment into the company’s 401k plan as a new employee. Just check to be sure the percentage that is being put into your 401k is enough to get the full match.
Step 2: Contribute to the HSA up to the Employer Match
If your employer has a health savings account (HSA) with their high deductible health plan (HDHP) and offers an employer contribution to the account, you should take full advantage of it just like the employer match for the 401k. Again, it’s free money and healthcare is only going to get more expensive in the future.
There is no real difference between choosing to contribute to a 401k or HSA first when there is an employer match. Pick the one that your company offers the highest contribution match for and contribute to that one first. Once you’ve gotten the full match, move on to the other.
The reason this listed as the second choice behind the 401k is because a HSA might be just a plain savings account without any investment options. That said, there is nothing preventing you from moving funds from your employer-sponsored HSA once they are deposited to another HSA administrator of your choosing, including to a HSA with investment options.
Step 3: Max Out Your HSA
Contributing to your HSA until you’ve hit the annual max contribution limit is the next step. For 2023, you can contribute up to $3,850 to your HSA as an individual and $7,750 as a family.
The reason to fund your HSA next is the triple tax benefits of the HSA. The money you put in the account are pre-taxed dollars and are not subject to federal income tax, similar to the 401k or Traditional IRA. Any earnings in the account grow tax-free, just like a 401k or Traditional IRA. After you turn 65, you can use your HSA for any purpose, even for a vacation, and you only pay regular income tax, just like a 401k or Traditional IRA. What makes the HSA superior to a 401k or IRA though, is when you withdraw the funds for qualified medical expenses, the withdrawals are completely tax-free.
Step 4: Make Maximum Contributions to Your Traditional IRA or Roth IRA
The Traditional IRA and a Traditional 401k have similar taxation. So which one should you choose? And what about the Roth IRA?
The reason you might want to pick the Traditional IRA over the Traditional 401k is because the Traditional IRA gives you more control over your investments. Your workplace chooses the 401k administrator and you could be stuck with limited investment options, high expense ratios, and high administrative fees. But if your 401k doesn’t have any of those issues, then it’s your choice on which one to fund first.
Another thing you should consider is that you can contribute to both a Traditional IRA and a Roth IRA at the same time as long as the combined contribution to both doesn’t exceed the annual IRA contribution limit.
Here is what I’d do:
- Bad 401k plan at work and you want to pay less taxes now? Max out your Traditional IRA first.
- Good 401k plan and you anticipate being in a lower tax bracket in retirement? Max out the Traditional IRA or 401k.
- You want to pay less taxes in retirement, hedge against higher tax rates in retirement, or think there is a possibility you might need to use the money to pay for a first home purchase or education expenses? Max out your Roth IRA first.
- Your income is way too high to contribute to a Roth IRA or a Traditional IRA and get the deduction? Max out your Traditional 401k first to reduce your modified AGI and re-evaluate. If it is still too high, contribute to the Traditional IRA next. You won’t get an upfront tax deduction for your contribution, but you can defer taxes on your earnings in the Traditional IRA.
- Your modified AGI after contributing to a 401k is too high to get the full tax deduction on a Traditional IRA but less than the limits for Roth IRA? Contribute to the Roth IRA to hedge against higher taxes in the future.
Be sure to read about all the benefits of a Roth IRA that the Traditional IRA doesn’t offer.
Personally, I prefer to have an IRA opposite what my 401k is. That way no matter what happens with tax policy in the future, I’d be covered.
Step 5: Finish Maxing Out Your 401k
After you’ve maxed out your IRA contributions, it is time to put what is leftover into your 401k. Contribute until you hit the 401k contribution limits for the year.
Like with IRA’s, you have the Traditional 401k and the Roth 401k. I prefer to go with the Traditional 401k to reduce the amount of taxes I am paying now. Each extra dollar you save from taxes can be invested now for it to grow into more money faster.
Remember the federal tax rate is graduated. The government levies more taxes on the higher amounts of income than the lower amount as seen on the federal income tax brackets. Each dollar you save into a pre-tax account is one less dollar taxed at the highest marginal rate.
But that doesn’t mean you should discount the Roth 401k. If you are in a career where you will be making massive earnings later in life, for example, doctors; investment banking; lawyers; dentists; etc, consider contributing to the Roth 401k first when your taxes are low. Then switch to the Traditional 401k when you make more money in your career.
Step 6: Save to a Regular Brokerage Account
After you’ve gone down the list and saved to all the retirement accounts available, don’t think you are out of options and your job is done with saving for retirement. If you still have extra money to put away, you can still put that extra money into a standard investment account at your favorite brokerage.
There may not be any special tax breaks for using a taxable brokerage account, but you also won’t have money sitting in a low-interest saving account barely catching up with inflation.
This step is even more important if you are working at a job where you aren’t offered any retirement benefits. Just because you don’t get a tax deduction or a company match doesn’t mean it isn’t worth saving for retirement. We all get old and retirement is coming whether you are ready or not.
By contributing to each of the accounts in the above order, you will be making the most out of your pre-tax retirement funds. Should you not have one of the above accounts available to you, for instance, you don’t qualify for a HDHP and can’t save to a HSA, then skip to the next step on the list.
At the end of the day, investing any money for your future is better than putting it off for later. The earlier you start investing, the more time for compound interest to kick in. Once it does, your net worth will skyrocket.
If you have trouble getting started, one of the best ways to save a ton of money fast without it being noticeable in your budget is to deduct it from your paycheck before it hits your bank account and giving yourself a chance to miss it.
What is your preferred order for saving for retirement? Which account do you give priority?