Most things have an order to them. Building a house, planting a garden, making a meal. Retirement planning is no different. In order to maximize your savings and earning potential, there are recommendations on the right order of retirement savings, including which “buckets” or accounts to invest in to get the most value. There is a difference between a retirement account and an investment. An investment is a stock, bond, mutual fund, index fund and so forth that you buy in the hopes to grow. An account, on the other hand, is the bucket or container that holds those investments and also the place where you contribute and buy investments. There are so many different accounts that exist. From 401ks to IRAs to HSAs, it’s a lot to take in. I’m often asked by friends and colleagues how I go about investment money for retirement, and in what order I do so. I’ve put together these steps to help you understand how to maximize your savings.
- Step 1. Get your 401k/403b match. If you work for a company that offers a 401k or 403b with a match, you should absolutely contribute the amount to get that match. For example, my employer matches 100% of the first 5% of contributions. By contributing 5%, I get 5% deposited into my account. If you do not elect at least 5% of your pay toward your 401k, you are missing out on free money! The 5% invested out of your paycheck is a 100% return on your investment. Take it! Tip: Make sure you know your employer’s vesting policy. If you leave the company prior to your match being 100% vested, they may take the money back.
- Step 2. Max out your Roth or traditional IRA. A Roth IRA is an individual retirement account where your money goes in after tax. This means that you do not get a tax break today, but when the money comes out later, the original amount you put in, plus the gains that you’ve made over time on your investments, are NOT taxed. A Traditional IRA, on the other hand, is a retirement account that gives you a tax deduction in the year you deposit into the account, but when you withdraw money later, it is subject to tax. Even if you have a retirement account from work (401k, 403b, etc.), you can still contribute to an IRA. The annual contribution limit in 2021 and 2022 is $6,000 total across IRAs. If you have a spouse or partner, each of you can contribute to the maximum contribution limit. There are, however, income limitations imposed by the IRS limiting the ability to deduct contributions to the traditional IRA as well as income limitations on who can contribute to a Roth IRA at all. If you are a high-income earner, there is a maneuver called a backdoor Roth IRA contribution, allowing you to contribute to a Roth IRA regardless of your income level.
- Step 3. Invest in a Health Savings Account (HSA). An HSA is an amazing retirement vehicle. Health care costs have increased significantly over the years, so HSAs provide a great opportunity to save when you’re healthier, preparing financially for future years when you might need additional care, long-term care not covered by Medicare and so forth. HSAs can play a huge role if you plan to retire early prior to being Medicare eligible at age 65, as it can help cover your health care expenses during those gap years. In order to contribute to an HSA, you must be enrolled in a qualified high-deductible health plan. For 2021, the annual contribution limit (including whatever monies your employer kicks in) is $3,600 for individuals and $7,200 for families. For 2022, the contribution limit for individuals will be $3,650 and for families, $7,300.
- Step 4. After you’ve maxed out your IRA and HSA (if applicable) for the year, max out your 401k. Currently, the maximum annual contribution you can make (doesn’t include your employer’s match) is $19,500 in 2021. In 2022, this maximum annual contribution will be bumped to $20,500. If you are 50+, in 2021, you can make an additional $6,500 “catch-up” contribution to the account. The catch-up amount is expected to be the same for 2022.
- Step 5. SEP IRA. If you side hustle or own a business in addition to working for an employer who offers a 401k, there’s good news. You can contribute funds to both types of accounts. For 2021, contributions an employer (you) can make to an employee’s SEP-IRA cannot exceed the lesser of 25% of the employee’s compensation or $58,000, whichever is less.
- Step 6. Invest in a non-retirement standard brokerage account. Once you have exhausted all of your contributions to the above, congratulations, you’re in a great place! A standard brokerage account is an investment account that allows you to invest in stocks, bonds, ETFs, mutual funds and a number of other investments, but there are no tax deductions on the contributions you make. Additionally, unlike retirement accounts, when you buy and sell investments in the account, the gains are subject to capital gains taxes. Brokerage accounts can play a significant role for those seeking to retire early. If you retire at 50, for instance, money here can be used to provide income to you until you’re able to access your retirement accounts. Currently, capital gains are taxed separately (and at a lower rate) from ordinary income (i.e. W2 income). If your income is less than $80k per year, your capital gains tax could be 0%!
- Step 7. Social security. Unless you have some unique privilege where you’re able to “opt out” of social security, chances are, you’re contributing out of every paycheck just like me. There are LOTS of opinions out there regarding the future of social security. 71% of Americans believe it will not be around to support them when they retire. Depending on your age, the future could look different. Some believe it will move to a means-tested program, meaning if you have wealth or income, what you receive could be reduced. My personal opinion is that it will be around in some shape or form well into the future. There are many people in Washington with careers at risk if the cart gets disrupted too much. My personal plan (at age 43) is to plan for a 50% level. If you are planning to retire early, the important thing is to make sure you have established for full social security work credits to be eligible for your payout. You can check in with the Social Security Administration to determine how many credits you have earned thus far.
As you can see, the order of retirement savings is important. What you do with the money inside those “buckets” or accounts is another story – what you invest IN matters as well. On your path to financial independence, planning for retirement savings is a critical activity. Whether you’re just getting started today or working to readjust your approach, thinking through and applying an “order of operations” matters.
Happy planning!
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