A Hierarchy for Retirement Savings

There are several account options available to investors for retirement savings purposes, including 401(k)s (403(b), 457, and the equivalents), IRA(s), and taxable accounts.

One question investors often ask is, if they have a fixed sum of money to invest every month or every year, how should they allocate that cash for their retirement savings? Which account(s) give them the biggest bang for their buck?

As with many financial planning questions, there are no one size fits all answers: variations in investors’ company retirement plans, personal tax situations, and financial goals and associated time horizons mean that a retirement savings hierarchy that makes sense for one individual may not add up for another.

That said, the following framework for retirement savings will be a good starting point for many investors.  Note that this hierarchy does not factor in non-retirement financial goals, such as amassing an emergency fund, saving for college, or investing for short and intermediate term financials.

Priority 1: 401(k) (other company retirement plan) Up To Matching Contributions

If your employer offers a 401k company match policy, your first priority for retirement savings should always be to contribute at least enough to earn the full company match.  You cannot ignore a 401(k)-matching contribution because there is nowhere else you can get an immediate 100% return (doubling your money) on your contribution.

Priority 1A: Health Savings Account (HSA)

While a Health Savings Account (HSA) is not necessarily an account specific to retirement, given ever-increasing healthcare and medical related costs, HSAs have been included as part of this framework.  Because Contributions, Earnings and Growth, and qualified Withdrawals are all free of tax, maximizing contributions to HSA accounts are a high priority.

Priority 2: Roth IRA (self and spousal)

Earnings and Growth, and qualified withdrawals from Roth IRA accounts are tax-free.  Roth IRAs also provide low cost, self-control, and increased flexibility compared to other alternatives, making them a high priority option for retirement saving, especially for those targeting an early retirement.

Priority 3: 401(k) (other company retirement plan) Up To the Limit

For higher income investors who have significant assets to invest toward their retirement savings, taking advantage of all tax-sheltered retirement savings options should precede investing in non-retirement accounts.  Investors in traditional 401(k)s contribute pretax dollars and enjoy tax deferred compounding; further, making pretax contributions reduces adjusted gross income, thereby increasing eligibility for valuable credits and deductions.  Those tax benefits are the key reason that investing in a 401(k) trumps investing in a taxable account.

Priority 4: Taxable Account

Investing inside of a taxable (non-retirement) account offers the most possible flexibility, albeit without the tax breaks that accompany the aforementioned investment account options.  Not only can you invest in nearly anything inside of a taxable account, but there are no withdrawal requirements either.  You can pull the money out whenever you need it, but you can also let it build for as long as you want; any taxable assets that your heirs inherit from you will receive a step up in basis, too.

And while you’ll need to invest after-tax dollars in the account, you’ll owe capital gains taxes (lower than ordinary income taxes, and 0% for investors in the 10% and 15% income tax brackets) when you sell.  This Taxable Account posting details some of the important benefits that come along with taxable accounts.  Utilizing taxable accounts also provides for tax diversification in retirement, especially for savers who may already have a sizable share of your assets in tax-deferred and Roth accounts.

As attractive as all of that flexibility is, the tax benefits provided by IRAs and company retirement plans usually make up for any extra costs or other drawbacks associated with those plans, especially for investors with longer time horizons.