We all know we need to save for retirement, but it can be tricky to know which of all the various tax-advantaged accounts to prioritize with our limited savings. Making the wrong choice could cost us in higher taxes, less flexibility, or even missing out on free money. Here are some factors to consider in prioritizing your retirement savings:
Did you max out a Roth IRA?
The main advantage of a Roth IRA is that any earnings are tax-free as long as you’ve had the account open for at least 5 years and are over age 59 1/2. However, you can also withdraw the sum of your contributions for any reason with no tax or penalty in the meantime. Any earnings you withdraw before 5 years and age 59 ½ may be subject to taxes and a 10% penalty, but the contributions come out first. (Exceptions to the 10% penalty include education expenses and up to $10k for a first-time home purchase.)
Since you always have access to the contributions, they can double as part of your emergency fund. If you already have emergency savings, you can simply contribute them to a Roth IRA up to the annual limit. Just be sure to keep the Roth IRA somewhere safe and accessible like a savings account or money market fund until you’ve built up an adequate emergency fund (enough to cover at least 3-6 months’ worth of necessary expenses) somewhere else. At that point, you can invest the Roth IRA more aggressively to grow tax-free for retirement.
If you don’t have an emergency fund, having at least a few thousand dollars in cash reserves should be your first priority. Otherwise, you could find yourself raiding another retirement account (and possibly paying early withdrawal penalties) or falling behind on rent, mortgage or car payments in an emergency. Having to complete a withdrawal form to tap your Roth IRA could also discourage you from tapping it for frivolous things.
If your income is too high to contribute to a Roth IRA, you can contribute to a traditional IRA and then convert it to a Roth IRA. As long as you don’t have any other pre-tax IRA money, you only pay taxes on the earnings you convert. If you do have other pre-tax IRA money, see if you can roll them into your employer’s retirement plan by the end of the year to avoid some tax complications.
Does your employer match retirement plan contributions?
If so, maxing that match should be your next priority. Where else are you going to get a guaranteed return on your money? Don’t leave that free money on the table! Of course, you also get all the other benefits of your retirement account like pre-tax contributions or tax-free growth, possibly low cost or unique investment options, the ability to borrow against it and pay yourself the interest, and creditor protections.
Are you eligible to contribute to a health savings account (HSA)?
If you’re enrolled in a qualified high-deductible health insurance plan, you can make pre-tax contributions to a health savings account and use the money (and any earnings) tax-free for qualified healthcare expenses. Whatever you don’t spend on health care now can typically be invested and used for any purpose penalty-free after age 65 as part of your retirement savings. The money could also be used tax-free to pay for qualified medical expenses in the future, including some Medicare and long-term care insurance premiums. When you consider that you’ll most likely have medical expenses in retirement, you might even want to try to pay for healthcare costs from other savings. This allows the HSA money to grow as long as possible to be used tax-free for healthcare costs in retirement.
Are you eligible to contribute to a 457 plan?
This retirement account is available to many public sector employees and has the same tax benefits and contribution limits as a 401(k) and 403(b). However, there is no early withdrawal penalty. This added flexibility gives it a priority over the others if you’re under age 55.
Have you maxed out your employer’s retirement plan?
If not, this should be your next priority for all the non-match reasons given under #2. Keep in mind that even if you’ve hit your pre-tax/Roth limits, your plan may allow you to contribute after-tax. You can then convert the after-tax dollars to a Roth account so they can then grow to eventually be tax-free. Some plans allow you to do a Roth conversion while you’re working there. Otherwise, you can roll the money to a Roth IRA.
Are you investing tax-efficiently outside tax-advantaged accounts?
If you’ve maxed out all of your eligible tax-advantaged accounts, you can still save and invest for retirement in a regular investment account. Since your interest, dividends, and capital gains will be taxed each year, you’ll want to use this account for the investments that generate the least taxes. That means individual stocks and ETFs, low turnover mutual funds, and municipal bonds. Taxable bonds, high turnover mutual funds, and REITs should be held in the tax-sheltered accounts as much as possible. If you’re not sure how to do that, it could be a good reason to hire a financial advisor or use a tax-aware robo-advisor.
As you can see, knowing which accounts to contribute to first isn’t always straightforward. If you’d like additional help making this decision, consider consulting a qualified and unbiased financial professional. Don’t let this lead to analysis paralysis though. Contributing to a less than ideal account is still much better than not contributing at all.