The Retirement Savings Order of Operations

There is no shortage of options for saving for retirement. Choices are great, but they can also make things difficult when you have so many of them. The sketch by Carl Richards below perfectly sums up the relationship between the amount of options a person has and the chances of actually getting anything done.

Image Source:  Carl Richards

Image Source: Carl Richards

So, between an employer retirement plan, IRAs, savings accounts, regular investment accounts, and a myriad of other options, where should your retirement dollars be going, and in what order?

Before I get into the specific order in which you should be funding your retirement, I have to mention one factor that trumps everything else: the amount you’re saving. If you are not setting enough money aside on a regular basis for retirement, none of this post matters. The biggest factor, by far, in setting yourself up for a successful retirement is increasing the amount you’re saving. Plain and simple.

Now, How About That Order?

1. Your Employer’s Retirement Plan

The first place you should look to save for retirement is in your employer’s retirement plan. How much? I always recommend that people invest AT LEAST up to the entire match that their employer provides. Why? I’ll give you several reasons:

  1. It is free money. No extra work required.
  2. Would you ever turn down a raise? Of course not. You are essentially turning down a raise if you’re not getting all of your employer’s matching contribution.
  3. 100% IMMEDIATE return on each dollar invested. I can’t think of anywhere else that guarantees an immediate doubling of your investment. Have an employer that does a partial match? I can’t think of anywhere else that guarantees an immediate 50% return either.
  4. It comes straight out of your paycheck. The reason that 401(k)s and plans like it have been such great tools for people over time is not because the investments have always been stellar, nor that the individuals investing in them have been investment gurus. Rather, it is because the 401(k) is a systematic way for people to contribute to retirement without the money ever touching their hands. It forces you to be disciplined in placing a set amount aside each month, regardless of what the market is doing.

Now, there are several factors that can complicate this decision. Your employer may have an extended vesting period that limits your ownership of your employer’s contributions until you have worked there for a certain period (anywhere from 1 to 6 years). However, if you plan on remaining at your job longer than a couple years, I would still contribute.

Another limiting factor could be that your employer doesn’t match at all, or maybe you can’t even contribute to your employer’s plan. You may have what is called a defined benefit plan, or some sort of pension or formulated retirement that is based on your salary and/or years of service. If these are the case, proceed to #2.

2.) High Interest Debt

Compound interest is a powerful thing. It can turn a molehill into a mountain given enough time.

There are two types of compounding returns: Ones that are working for you and ones that are working against you. Just as the compounding returns work for you in your investments, they work against you in your debts.

My rule of thumb is that if you have debt with an interest rate of 7-9% or higher, you are better off paying off your debts before focusing on investing.

Why?

Although the long-term average return of the market is around 10%, many experts feel that future growth will be lower and that 7% is a better forward-looking estimate (Investopedia). In reality, no one knows what the market will look like going forward. All we have is history and projections based off of that; nothing is guaranteed.

If you have a credit card debt at an interest rate of 19.89%, you have no business expecting your investments to outperform that debt. Likewise, if you have student loans at an interest rate of 9%, you can’t expect with reasonable certainty that your investments will outpace that debt.

3.) Roth IRA

The next step after you invest up to your employer’s match and have eliminated hight interest debt is working towards maxing out a Roth IRA if you are eligible. A Roth IRA is similar to a 401(k), but with some key differences. The main differences for the purposes of this article are:

  1. With a Roth IRA, you pay the taxes on your contributions now, as opposed to in retirement like in the 401(k).
  2. The IRS has an income phaseout on who is eligible to contribute to a Roth IRA. These limits are currently $117,000 to $132,000 single and $184,000 to $194,000 married filing jointly for 2016(IRS). There are no income limits in 2016 for 401(k)s.
  3. The IRS places a limit on how much someone can contribute to an IRA. For 2016, this limit is $5,500 per individual per year, $6,500 if you are above age 50 (IRS). This limit is $18,000 per year for 401(k)s.
  4. You have a wider range of investment options available in an IRA, as you are not limited to what is offered in your employer’s plan.

The difference in taxation may seem like a minor difference, but it can have a major impact on future net (after tax) retirement benefits. The question on whether or not your retirement dollars should be placed in a Roth or in your 401(k) or Traditional IRA is all based on one thing: taxes. If you expect your income to increase between now and the time you retire or if you are young, you are likely better off going with the Roth. If you believe that you are at the peak of your lifetime annual income, you may be better off deferring your taxes through contributing to your 401(k).

4.) Where Do Your Retirement Dollars Go From Here?

By now you will have invested up to the employer match at your work, eliminated your high-interest debt, and maxed out a Roth IRA (if you are eligible). From there, it makes sense for most people to focus on placing additional money in their employer retirement plan. After allocating a sufficient amount towards retirement, many with excess cash flow choose to open a regular investment account for intermediate and long-term goals.

There is no blanket answer for every person, but the above process is a prudent method for many to go about saving for retirement.