It’s hard to provide a one-size-fits-all approach to saving. Everyone has different savings strategies and financial goals which are important to factor into the decision-making process. However, this method works for the vast majority of our clients. I find it important to view savings as a “waterfall” with many different pools. The first pool must be filled completely before any additional savings can cascade to the next pool.
First pool: Matched money from your employer
Saving enough to reach the full match should be the first place you focus your saving power. If you are eligible for a savings plan through work – whether that is a 401(k), Health Savings Account (HSA) or Employee Stock Ownership Program (ESOP) – and the company will match the dollars that you put into the program, this is by far the best place to save first. If they match your savings 1:1 or 1:2 in any of these accounts, you are automatically getting a huge return on investment that you can’t pass up.
Second pool: Paying off expensive debt
Paying down debt faster than the required scheduled payments is a form of saving that increases your net worth. However, not all debt is equal. There is cheap debt and there is expensive debt. You shouldn’t pay off all of your debt without doing a little analysis. First, determine the interest rate on the debt and amount of years left on the loan. Next, compare the interest rate on the debt to what your investments should earn over that same time period.
Paying off the debt is the equivalent of locking in the debt’s interest rate as your return on investment. If you can choose between earning 7% on your investments or paying off a 4% mortgage loan, you could create more wealth by not paying down the loan faster. However, if you have 5 years left on your student loans and you are paying 6% interest – there is far less certainty that you can beat a 6% return over the next 5 years. In this case, the possibility of higher returns doesn’t outweigh the benefit of paying down the loan quicker.
There are also extremely important psychological benefits of having less debt as well. We should not make all financial decisions in a quantitative vacuum. If you will sleep better at night knowing you are debt-free, be sure to factor that into your decision-making process.
Third pool: Health Savings Account
The next best place to maximize your savings is in an HSA-eligible plan. As of 2019, you are limited to contributing $3,500 as an individual and $7,000 if you are a family with an additional catch-up contribution of $1,000 if you are over the age of 55.
To properly use an HSA, you should save money in the account but not reimburse yourself for the medical expenses you incur. This means that you accrue reimbursable money that you can take out of your HSA at any time in the future. You will inevitably have medical expenses over the course of your lifetime, so saving in the HSA now and letting the money grow tax-free will allow you to distribute high amounts of tax-free income to cover your retirement needs. See this post to read more about the best HSA saving strategy.
Fourth pool: Comparing tax brackets
You are left with two options for saving in tax-advantaged accounts: pre-tax versus post-tax retirement accounts. Your pre-tax options are a Traditional IRA or a Traditional 401(k). Your post-tax options are a Roth IRA or Roth 401(k). Which account you should save in is dependent on your tax bracket now and your expected tax bracket in retirement. If your situation is similar to most people, your tax bracket should be higher now than what it is projected to be in retirement. In that instance, it would be best to maximize your savings in your Traditional IRA or 401(k).
However, Social Security, Premium Tax Credits, and the Income Related Monthly Adjustment Amount can actually cause your tax bracket to jump for various levels of income in retirement. These events may leave you in higher tax brackets than you are currently in, in which case we need to do some analysis to determine which account is truly best.
Fifth pool: After-tax contributions to a 401(k)
Also known as the mega backdoor Roth contribution – this is only allowed for 401(k) plans that allow after-tax contributions. This lesser-known strategy allows you to contribute a total of $55,000 (or $61,000 if you are over age 50) to your 401(k) without receiving a tax deduction. These are effectively Roth contributions. However, to truly benefit from this strategy, your 401(k) plan must allow non-hardship in-service rollovers. The balance of the 401(k) can then be rolled out of the plan and into a Traditional and Roth IRA based on the amount of each contribution made. This allows the after-tax contributions to grow tax-free in your Roth IRA. All of the investment growth is considered taxable growth if you leave the after-tax contribution in your 401(k). That is why the in-service rollover is crucial.
This strategy is only for savers who are looking to save tens of thousands of dollars above the 401(k) limit and have the exact 401(k) plan to do so.
Sixth pool: Taxable brokerage account
If you still have the capability to save after this point – kudos on being a good saver! The last place I recommend saving is in a taxable brokerage account. This account receives no tax-free growth benefits but is subjected to favorable capital gains and dividend rates as long as you hold assets for longer than a year. You should choose to hold assets in this account that benefit from the specialty treatment while avoiding taxable interest income as that is taxed at higher ordinary income rates.
I did not mention college savings in this post because it should be a separate planning issue subject to its own plan. I generally recommend filling up at least the first three pools before saving for college.
I also did not mention variable annuities. This is because variable annuities are a decision to be made using the money in either your IRA or your brokerage. Generally, I do not recommend variable annuities for the clients I work with because it is not right for them. Fixed annuities are a topic of conversation during the retirement transition.
While one size rarely fits all, we hope this is a good guide on how to save for retirement in the most tax-efficient manner. Reach out to us if you would like help in developing a plan that maximizes the tax incentives that are out there for you.