Retirement Savings Waterfall

With so many different types of savings and investment accounts available, it can be hard to know where to put the money you’re diligently saving. This savings waterfall will help you capture various tax incentives, which when compounded over many years, can add up to make a significant difference. The basic idea is that you fill up each bucket before going to the next, and if the bucket doesn’t apply to you, move on to the next.

How tax-efficient are your long-term savings and investment buckets?

1.       Get your employer’s full 401(k) or 403(b) match:

Fund your workplace retirement plan up to the maximum employer match level. Whether your employer matches dollar for dollar or 50% of your deferral, this is the closest thing to “free money” that there is, and you don’t want to leave it on the table. Don’t worry about maxing out your deferral yet (that will come later in the waterfall), just put in enough to get the full match. If a Roth option is available, read our article on whether to contribute to a post-tax Roth account or traditional pre-tax retirement account, but whatever you do, make sure you get the match, which will always be on a pre-tax basis.

2.       Pay off credit card debt:

with interest rates north of 21% annually, any credit card balance that’s not paid off every month quickly balloons into a costly spiral. Put differently, if I told you there’s an investment you could make that guarantees a 21% return, you should be extremely skeptical… but that’s exactly the return you can expect from paying down expensive credit card debt.

3.       Fund qualified education expenses with 529 plan contributions:

This does not mean fund your child’s college savings goal, that comes farther down the list. This is for qualified expenses that you’re already paying out of pocket in order to capture the state tax break. Examples of qualified expenses include college tuition/room/board or the first $10,000 of K-12 private school tuition. In Virginia, 529 account owners who are Virginia taxpayers may deduct contributions of up to $4,000 per account per year with an unlimited carryforward to future tax years. Therefore, a married couple can each contribute $4,000 for each child and receive an $8,000 state tax deduction, worth $475 per year. This is not based on any additional savings, just how to route the payments you’re already making and capture this “free” money.  Not all states allow this. See 529 Plan Hack: Maximizing state tax benefits by routing education expenses through a 529 plan. — Oakleigh Wealth Services for more information, and be sure to check your state’s rules.

4.       Build up an adequate emergency fund:

rule of thumb dictates that your emergency fund should be between 3-6 times your monthly non-discretionary expenses. Typically, these funds would be saved in a money market savings account with a competitive interest rate, but there are other places you could keep these funds, including a brokerage account or even a Roth IRA, which allows for tax-free/penalty-free withdrawals of contributed amounts for any reason. You need an adequate emergency fund so that you don’t need to dip into your retirement savings or go into debt if the unexpected happens.

5.       Fund your HSA:

Often, these accounts will come with an employer match (free money) and are “triple tax-free,” meaning they’re funded with pre-tax money, the investments grow tax-free, and distributions are tax-free if used for qualified medical expenses. Even if you don’t expect major medical expenses in the near future, nearly everyone experiences a medical emergency at some point in their lives, and there is also a wide range of things that qualify for tax-free distribution (COBRA premiums, vision care, medications, long-term care insurance premiums, Medicare premiums). Plus, if you’re over 65, there’s no 20% penalty tax on HSA withdrawals, even if they’re not for qualified medical expenses (you would just pay income tax, the same as you would for traditional IRA or employer retirement plan distribution). For more info on how to maximize the benefits of your HSA, check out Maximizing Your HSA’s Full Potential: Stop Using It Like an Expense Account — Oakleigh Wealth Services

6.       Max out your Roth IRA annual contribution (or consider a Backdoor Roth Strategy):

Roth IRAs are an extremely tax-efficient and flexible way to save for retirement (and a range of other expenses or goals). When you fund a Roth account, you don’t get any immediate tax benefits because you’re funding with after-tax dollars. Still, you get tax-free growth and tax-free distributions after age 59.5 or for certain other qualifying reasons (first home purchase, education). Also, unlike traditional IRAs or employer retirement plans, you can always withdraw your contributions without tax or penalty at any time (and can withdraw Roth conversion amounts after 5 years). For someone who’s AGI is greater than the Roth IRA contribution limits, consider pursuing a backdoor Roth strategy. Note that there are some situations where it may make sense to prioritize pre-tax savings over Roth contributions in order to capture the tax deduction in the current year. This situation is more likely to apply to very high earners, especially when they expect to have a lower income in the future when they can execute a Roth conversion. For most people, though, funding a Roth is their best move.

7.       Max Your Employer 401(k) or 403(b):

If you still have more money to stash away for retirement, now is the time to fill up this bucket. Remember, you’ve already captured the employer match, so this is all about making tax-advantaged savings. If your employer offers a Roth option, then many folks can benefit from paying tax on this money now in exchange for tax-free growth and distributions in the future (see Optimizing Traditional vs. Roth Retirement Savings). If you’re self-employed, consider opening a solo 401(k), which are low cost and easy to administer. Increasingly, employers are offering 401k plans that allow for the so-called “mega-backdoor Roth contributions,” which enable even larger after-tax contributions to Roth accounts. Check out Can I make a “Mega Backdoor Roth” Contribution? — Oakleigh Wealth Services

8.       Defer to a 457 Plan:

If you work for the government or a non-profit, you may have access to a 457 plan. While 457 plans have the same deferral limits as 401(k) or 403(b) plans, they are separate, meaning you can contribute the maximum amount to both a 457 and an employer-sponsored plan. Keep in mind that those limits apply across employers, so you cannot contribute more than the maximum to either category just because you have two unaffiliated employers. 401(k) and 403(b) plans also offer slightly more flexibility and protection, so prioritize those first, then fill up the 457.

9.       Contribute to a SEP IRA or other Employer-Sponsored Plans:

If you have self-employment income in addition to regular employment with a 401(k), you can also make contributions to a SEP IRA, which has its own separate contribution limits based on the Keogh limits. Because these are IRAs, you can roll them over to a Roth whenever you want (though keep in mind that there will be tax consequences if you have any IRAs with non-deductible contributions). Certain self-employed individuals with high incomes who are nearing retirement may reap greater benefits from establishing a defined benefit pension plan, potentially allowing for significantly greater deferrals in certain situations. If your employer offers other deferred compensation options, this is also the step at which you should consider those.

10.    Fund a 529 plan for future education expenses:

If saving for your children's or grandchildren’s education is your goal, now is the time to capture that annual state tax deduction (if available). These funds will grow tax free and can be distributed tax free for qualified educational expenses, plus you will retain the authority to select and change the beneficiary in the future, or even withdraw the money yourself (subject to a 10% penalty tax). 529 plans have been called the “poor man’s trust” because they enable the owner to fund the education of future generations in a tax-efficient manner by utilizing the annual gift tax exclusion, as they are considered a completed gift. You can also front load 529 plan contributions with up to 5x the annual gift tax exclusion amount and then spread the exclusion over 5 years while removing the funds from your taxable estate.

11.   Save in a regular, taxable brokerage account:

Savings held in a taxable brokerage account are the most flexible of all the above buckets, giving you options both before and after retirement. Firstly, there are no age-based restrictions or qualifications for using funds from a taxable account for anything. It’s 100% your money! You can use this money at any time for any (lawful) use.

Having a sizeable taxable account also allows you to pursue planned charitable giving, conversion, and withdrawal strategies before and during retirement that would not be as feasible if all your savings were tied up in pre-tax savings. Yes, you’ll be taxed on investment income and capital gains, but you can minimize their impact through efficient asset location.

Lastly, there are many reasons you would wish to make contributions to a taxable brokerage account prior to other items on this list (saving for a large purchase, creating an emergency fund, needed flexibility, etc.), but since this is strictly a retirement savings waterfall, generally, savings for retirement in a taxable brokerage account fall at the bottom of the priority list.

 (Not) the Final Word

This list is not exhaustive and may not apply to everyone or to all situations. This article does not address investment allocation strategies, asset location, and customized tax analysis, which are part of a holistic retirement plan, as well as other considerations for prioritizing and addressing other short-term and long-term goals. Reach out if you are interested in exploring this more fully as part of a holistic financial plan!