The Best Order For Saving For Retirement
401ks, IRAs, and HSAs oh my!
I'm a big fan of methods and orders of operations for doing things. I think that it is essential to have a set plan for executing tasks, especially long term tasks like saving for retirement. But what's the best way to go about funding retirement? What is the proper order to save? Let me break it down for you:
Step 1 - Save in Your 401k (Up To The Match)
The first step in saving for retirement is to take advantage of your for 401k or 403b, up to your employer match. These are great plans that every eligible person needs to participate in, and when your employer matches your contributions, it's free money! Funding your retirement in a 401k is a great way to save because it gives you a tax savings when you contribute, your investments grow tax deferred, and in many places, your company matches your contribution up to a certain percentage.
If your company matches your contribution, and you don't contribute, you're leaving free money on the table, which is crazy! It's essentially giving up a percentage of your pay!
Plus, saving for retirement in a 401k is easy. All you have to do is sign up.
Step 2 - Fund Your Roth IRA
Once you’ve earned the full company match on your 401(k) contributions for the year, focus on maxing out annual Roth IRA contributions if you’re eligible (if you are not eligible the Backdoor Roth IRA is always an option). If a Roth option is available in the 401(k), an individual should fund the Roth 401(k) before attempting to contribute to the Roth IRA account. This is due to the lack of income limitations.
A Roth IRA allows you to make post-tax contributions, but you won’t pay taxes on gains, including dividends, capital gains, and interest earned. The sooner you get your money into the Roth, the longer it will have to compound tax-free.
Step 3 - Continue To Max Your 401k Contributions
If you've already maxed out your IRA contributions, it's time to look at maxing you your 401k contributions. In 2020, you can contribute $19,500 into your 401k pre-tax, and you can have a total contribution to your 401k (employee + employer contributions) of $57,000.
If your employer allows after-tax, non-Roth contributions, and you can afford it, you might consider maxing this out so that you can potentially take advantage of the Mega Backdoor Roth IRA.
Step 4 - Max Your HSA
If you are in a high-deductible health plan, and you are eligible for a health savings account (HSA), you'd better be taking advantage of it to the max. I consider the HSA to be the secret IRA nobody is talking about, because it offers triple-tax benefits, and is simply an awesome way to save.
Plus, many employers offer matching contributions into an HSA, and many times the health insurance attached to the HSA is cheaper than other options offered.
The only reason that the HSA is #4 on this list is because many people simply don't qualify for it. However, if you do qualify for it, I'd move it to #2 - right behind taking advantage of your employer's match.
Step 5 - Save in a Standard Brokerage Account
After you've invested in both your IRA and 401k, you may not know what to do next. The best thing you can do after maxing out all the "traditional" retirement accounts is to just invest in a standard brokerage. This type of account has no special tax breaks for saving for retirement, but it comes in as Step 5 in our order of operations for funding retirement because it is important to invest versus just saving.
The key is to protect against inflation from eating your returns as you fund your retirement. If you just save the remainder in a savings account(CD, Money Market, etc), you don't grow your money or keep up with inflation. While saving is important, it is more important to grow your money over the long run by investing.
Conclusion
So, if you follow this plan to maximize your pre-tax retirement savings, you'll be following the best order for funding retirement. If you don't have an option available to you (i.e. your employer doesn't offer a 401k match), then just skip to the next step.