By: Nathan Larsen
Some of the most frequent questions I get from prospective clients is something along the lines of: “Where is the best place to be putting my money?” or “What types of accounts should I be prioritizing?” Due to the variety of options available and the many types of accounts, it can get very confusing to know which to prioritize. Squire Wealth Advisors has prepared a quick list to help you prioritize where your next dollar should go.
You can download a copy of our one-page cheat sheet using this link.
FYI, everyone’s situation is different but for most people the priority list of retirement savings is as follows:
- Emergency Savings Account
- Employee Retirement Plan Up to Company Match
- Health Savings Account (HSA) (HSA Eligible Plan)
- Retirement Plans (Up to Contribution Limit)
- Tax-Deferred Retirement Plans (Up to Contribution Limits)
- Roth/Traditional IRA
- Deferred Comp Plans
- 529 Plans
- After-Tax (Backdoor) IRA Contributions/After-Tax (Backdoor) 401k Contributions
- Taxable Accounts
- After-Tax Contribution
- Non-Qualified Annuity
1. Emergency Savings
If you’re a Dave Ramsey Fan, this is also baby step #1 in his process. For good reason, it is wise to have money socked away for unexpected events in your life. A general rule of thumb is 3-6 months of discretionary spending, but I consider that guidance to be a bit oversimplified. You really should be considering your goals, risk tolerance, family situation, type of employment, etc. to identify what amount is best for your situation. Check out this one-pager to help you decide how much is enough.
2. Company Retirement Plan Up to Company Match
Your company retirement plan match is free money. If your employer offers a 401(k) and the plan also includes a company match, it’s a no brainer to contribute up to the match. Let’s say your company offers a 3% match. If you make $100k and you put in $3,000, your company will match it dollar for dollar and contribute 3,000 into your 401(k). You have given yourself a 3% raise. After your emergency savings, this is a must do!
3. Health Savings Account (HSA)
If you have a high-deductible health plan (HDHP) the next step in prioritizing savings is contributing to an HSA. Even if your company or health care provider doesn’t provide one, you can set one up at various banks or HSA providers. These are fantastic, because you can put money in, get the tax deduction for your contributions, then take it out for qualified medical expenses and not pay taxes on the withdrawals. After the account reaches $2,000 you can invest anything over that $2,000 threshold. You can even use it for long-term retirement savings. For more details on how to do that and other awesome benefits of HSAs check out my colleague’s video, here.
4. Retirement Plans
Prioritization on this level would be a function of current vs. future marginal tax brackets, employer plan features, and balance between college savings goals vs. retirement goals.
Company Retirement Plans
Depending on plan features, it’s usually best to first max out company retirement plans like a 401k up to the contribution limits. In most cases you can contribute more to a company retirement plan than individual retirement accounts and there are no income phase outs.1
Traditional IRA & Roth IRA
In some case, you can contribute to both a company sponsored retirement plan and an IRA, but phaseouts exist that limit your contributions to IRAs based on your modified adjusted gross income (MAGI). Consult those phaseouts, before contributing to an IRA. IRAs operate similarly to a company 401k plan. Traditional IRA contributions provide a tax deduction in the year you contribute. Roth does not count as a tax deduction but grows completely tax free until you withdraw.
Quick Note on Pre-Tax (Traditional) Vs After-Tax (Roth)
Some company retirement plans allow for either pre-tax or Roth contributions. Pre-tax contributions reduce income in the year you contribute and allow your investments to grow tax-deferred until you eventually take out the money. After-tax or Roth contributions do not reduce your income, but all growth thereafter is completely tax free so long as you follow a few of the IRS’s rules when you take the money out. The best one for you depends on current vs. future marginal tax brackets. Typically, young professionals just starting out benefit most from Roth contributions. And seasoned professionals in their highest earning years benefit most from pre-tax contributions.
Deferred Comp Plans
Here, we are referring to non-qualified deferred compensation plans (NQDCs). These types of plans are typically offered only to top-level executives or key employees that a company wants to retain. There are no caps on contributions. NQDC plans usually pay out when you retire and can be a great way to defer that compensation and the tax that comes with it until retirement, when you are likely in a lower tax bracket. The downside is that the money in a NQDC plan does not have the same protection as a 401k and if the company goes bankrupt, creditors can take your funds.2
529 plans are specific to education savings and can be a fantastic tool to save for college. They have gone through some recent changes with the passing of secure Act 2.0 that makes them more flexible with a Roth conversion feature now available. Contributions to a 529 plan should be prioritized based on college savings goals and retirement goals.
5. After-Tax (Backdoor) IRA Contributions & After-Tax (Backdoor) 401(k) contributions subsequently converted to Roth
We recommend you take advantage of all the above accounts before making backdoor IRA contributions. Commonly called backdoor Roth and mega-backdoor Roth, these contributions allow you to make after-tax (Roth) contributions if you have maxed out your 401k and/or are phased out of making Roth contributions.
Simply put, a backdoor Roth IRA Conversion allows you to make non-deductible contributions to an IRA and then subsequently rolling that contribution to a Roth IRA. This strategy is typically used for those over the Roth IRA contribution phase-out limits because anyone can complete a backdoor Roth regardless of income. The process is complicated and you can run into issues with the pro-rate rule and filling out a special form needed on your tax return, so please consult your financial advisor and tax professional when considering this.
The process is like the Backdoor Roth, except it’s done in a company 401k plan. This is not possible with most 401k’s because it must be explicitly allowed in the 401k plan documents. Once, you max out your individual contribution limit on your 401k ($22,500 for 2023), you can make additional non-deductible contributions to your 401k up to the “section 415” limit. This limit is the combined employer and employee contribution maximum for the year. The 415 limit for 2023 is $66,000 so if you make $100k a year and contribute $22,500 to your plan and your employer matches 3% or $3,000 you would have $40,500 of room to make non-deductible contributions to your 401k plan if your company allows it. These contributions can then be subsequently converted to Roth money. Again, this process is complicated and most companies don’t allow it, so consult your company and your 401k plan documents as well as your financial advisor.
6. Taxable Accounts
After exhausting your tax free and tax deferred options, the next best place for your next savings dollar is a taxable account. This is just a regular brokerage account. While it doesn’t provide any tax benefits, it can be a great place to sock away surplus income for mid-term and long-term goals. Any dividends, interest, or capital gains realized in these accounts will be taxed in the year you realized them. When working with your advisor ask about tax savings strategies that are essential when investing in taxable accounts such as: asset location, tax-loss harvesting, and donating appreciated stock.
7. After-Tax (non-deductible) Contribution
See #5 above. After-tax (non-deductible) contributions are just the first half of a backdoor Roth or Mega-backdoor Roth. It’s a way to get money into a tax deferred account like a 401k. While not providing any tax deduction on contributions, and not converted to Roth, this can provide tax-deferred growth for tax sensitive investors.
8. Non-Qualified Annuity
Nonqualified variable annuities are tax-deferred investment vehicles with a unique tax structure. While you won’t receive a tax deduction for the money you contribute, your account grows without incurring taxes until you take money out, either through withdrawals or as a regular income in retirement.3
I don’t typically recommend annuities for most situations, because they are high cost and overly complicated, but for tax sensitive investors they can provide additional ways to defer taxes during high income years. Proceed with caution and consult a financial advisor, preferably one that isn’t trying to sell you the annuity.