How to Save for Retirement

The goal of this post is to provide a framework for where to save for retirement. We will review common tax-advantaged retirement accounts (401ks, IRAs, etc.) and lay out an order of operations for allocating your retirement savings each year. To answer how much to save for retirement, check out this post.

Tax-Advantaged Retirement Savings Accounts

Several tax-advantaged accounts are available for retirement savings depending upon your employment and income. What follows are the most common retirement savings vehicles, key features, and a recommended order to save in these accounts, primarily addressing employer-sponsored plans (401(k), 403(b), and 457 plans), IRAs (Individual Retirement Accounts), and HSAs (Health Savings Accounts).

Employer-sponsored plans (401(k), 403(b), 457)

401(k), 403(b), and 457 plans are very similar employer-sponsored plans, but are offered by different types of employers. 401(k)’s are offered by private employers, 403(b)’s are offered by public schools, churches, and certain 503(c) organizations, and 457’s are typically offered by state and local government employers. 

As an employee, you elect a percentage or dollar amount to be deducted from your paycheck, which is invested in your account. Many employers also offer a “match,” where the employer will make additional contributions to your account. At a minimum, aim to save enough to maximize your employer’s match.

 In 2022, the maximum employee contribution to these plans is $20,500. Those turning 50 or older are also allowed an additional $6,500 “catch-up” contribution. This limit applies only to your contributions. Your employer’s contributions (match, profit-sharing) can exceed this amount.

Individual retirement accounts (IRA's)

IRAs are available to anyone with earned income and are not tied to your employer. These accounts allow far more flexibility because you are not limited by your employer’s fund options.

Contributions can be made on a pre-tax (traditional) or after-tax (Roth) basis, although income limits apply to the deductibility of contributions and eligibility for Roth contributions. The maximum contribution for 2022 is $6,000 and those 50 or older are allowed an additional $1,000 catch-up contribution.

 Health Savings Accounts (HSA's)

HSAs are a third great retirement savings vehicle for those enrolled in a high deductible health plan (HDHP). The primary role of these accounts is to allow you to save pre-tax dollars for healthcare expenses, but HSAs double as potential retirement savings vehicles. As we consider saving for retirement, we will turn to HSAs after employer plans and IRAs because of a few extra strings attached. 

Withdrawals from an HSA can be made tax-free for medical expenses. Withdrawals for non-medical expenses will be taxed as income; in addition, there will be a 20% tax penalty on the earnings (growth) portion of your withdrawal. However, the penalty no longer applies at age 65; non-medical withdrawals after age 65 are only subject to income tax (this is the same treatment as a traditional IRA!).

Contributions to HSAs are made on a pre-tax basis and no income limits apply to contributions, although you must be covered by a HDHP. The contribution limits for 2022 are $3,650 for individuals and $7,300 for families. Different than a 401(k), the annual limit includes your contributions and employer contributions. As a result, if your employer contributes to your HSA, you must factor this into your contributions to avoid exceeding the annual contribution limit.

Order of Retirement Savings

Given this overview of tax-advantaged accounts for retirement savings, below is a framework for ordering your retirement savings.

1. Maximize the Employer Match
   • The first step is maximizing your employer’s match. This is “free” money and simply cannot be beat. For example, if your employer offers a 100% match on 3% of your contributions, at a minimum contribute 3% of your salary. The match will effectively double your contribution – an immediate 100% return.
2. Maximize IRA Contribution
   • The next step is contributing to your IRA. An IRA offers more flexibility in your investment options, allows you to better control costs (fund expenses, commissions), and you are not beholden to the funds selected by your employer plan. For these reasons, fund this account after maximizing the employer match.
3. Turn back to the Employer-sponsored plan
   • If you have maximized your employer's match and  IRA contributions for the year and want to save more for retirement, turn back to your 401(k), 403(b), or 457.
4. HSA
   • After maximizing your employer-sponsored plan and IRA, turn to the HSA as a retirement savings vehicle. The additional strings attached until age 65 are the main reason this account falls to #4 on this list.
5. Taxable account
   • Lastly, if you’ve maximized contributions to these tax-advantaged accounts, open a brokerage account and invest additional funds here. Taxable accounts do not have the benefit of tax-deferred growth like employer-sponsored plans, IRAs, and HSAs. Meaning you may owe taxes on any dividends, interest, and capital gains. For this reason, you will want to be particularly conscious of the tax-efficiency of your investments and strategy in this account.

Applying the Order of Operations

Below are a few examples of taking this order of operations and applying it to real-world situations. After you have decided the amount you want to set aside for retirement, you can follow these same steps.

 Example 1

 Joe is 28 years old, earning $80,000 and targeting 15% savings for retirement. His company matches 100% of his 401(k) contributions up to 3% of his salary. Here are the steps Joe will follow to reach his 15%, or $12,000, retirement savings goal.

1.  Maximize Company Match
   • Joe will defer 3% of his income into the 401(k) to get the full company match. Joe and his company’s contributions total 6%, or $4,800.
   • Step 1 total: $4,800; Remaining: $7,200
2. IRA 
   • Next, Joe will turn to his IRA and invest $6,000 (the annual maximum).
   • Step 2 total: $6,000; Remaining: $1,200
3. Return to 401(k)
   • Joe will go back to the 401(k) and increase his deferral by another $1,200, or 1.5% of income.
   • Step 3 total: $1,200; Remaining: $0

Example 2

Rachel and John are a married couple in their early 30s. Rachel earns $100,000 and John earns $80,000. Rachel’s company matches contributions to her 401(k) up to 6% of her salary. John’s employer matches 50% of his 401(k) contributions on the first 6% of his salary. Rachel and John would like to save 25% of their income towards retirement, or $45,000.

1. Maximize Company Match 
   • Rachel and John will both defer 6% of their salaries to maximize their employers’ matching programs. Rachel will defer $6,000 (6% of $100,000) and her company will match the full $6,000. John will defer $4,800 (6% of $80,000) and his company will match 50% of this amount, $2,400.
   • Step 1 total: $19,200; Remaining: $25,800
2. IRA 
   • Next, Rachel and John can each maximize their IRA contributions, $6,000 each.
   • Step 2 total: $12,000; Remaining: $13,800
3. Return to 401(k)
   • Rachel and John can then assess each of their 401(k) plans and decide how to allocate the remainder of their savings goal. Let’s assume both 401(k) plans are comparable and offer low-cost, indexed investment options. Rachel and John decide to split the $13,800 into additional $6,900 contributions to each of their 401(k) plans.
   • Step 3 total: $13,800; Remaining: $0

Example 3

Mike and Lisa are a married couple in their mid-40s. Both are entering their peak earnings years, with income of $160,000 each. They would like to save 25% of their combined income, or $80,000. Mike’s employer matches his contributions up to 5% of his salary. Lisa’s employer does not match 401(k) contributions. Mike and Lisa are covered by a high deductible health plan through Lisa’s employer. Lisa’s employer contributes $2,500 to Lisa’s health savings account (HSA) each year.

1. Maximize Company Match
   • Mike will defer 5% of his income, $8,000, and his employer will match the $8,000 contribution. Lisa’s company does not offer a match.
   • Step 1 total: $16,000; Remaining: $64,000
2. IRA
   • Mike and Lisa will each contribute $6,000 to through a backdoor Roth IRA.
   • Step 2 total: $12,000; Remaining: $52,000
3. Return to 401(k)
   • Mike and Lisa will both maximize their 401(k) contributions for the year. Mike has already committed $8,000 as part of step 1 and will increase his contributions by $12,500. Lisa will contribute the $20,500 maximum.
   • Step 3 total: $33,000; Remaining: $19,000
4. HSA
   • Next, they will turn to their HSA. The maximum contribution for a family plan is $7,300. However, unlike a 401(k) plan, employer contributions must be taken into consideration. Therefore, Mike and Lisa can only contribute $4,800 to their HSA plan this year. Lisa’s company is contributing $2,500 towards this annual limit.
   • Step 4 total: $7,300; Remaining: $11,700
5. Taxable account
   • After exhausting tax-advantaged account options, Mike and Lisa open a joint taxable account and invest the remaining $11,700.
   • Step 5 total: $11,700; Remaining: $0

And those are just a few applications of the retirement savings order of operations. Your own situation and mileage will vary, but taking these principles into consideration as you plan for your retirement savings each year will ensure a mindful approach to your tax-advantaged savings options.

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