I'm a big fan of methods and orders of operations for doing things. I think that it is essential to have a set plan for executing tasks, especially long term tasks like saving for retirement. But what's the best way to go about funding retirement? What is the proper order to save?
Remember back in elementary school the order of operations for math - "Please Excuse My Dear Aunt Sally"? I always found that useful - parenthesis, exponents, multiplication/division, addition/subtraction.
Its rules and order that make things easy to remember, just like PEMDAS from elementary school.
So, what is the best order of operations for saving for retirement? Let me break it down for you, and show you the exact strategy I'm using as well.
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The Order Of Operations For Saving
Let's start with a chart breaking down the best order of operations for saving for retirement.
Step 1 - Save in Your 401k (Up To The Match)
The first step in saving for retirement is to take advantage of your for 401k or 403b, up to your employer match. These are great plans that every eligible person needs to participate in, and when your employer matches your contributions, it's free money! Funding your retirement in a 401k is a great way to save because it gives you a tax savings when you contribute, your investments grow tax deferred, and in many places, your company matches your contribution up to a certain percentage.
If your company matches your contribution, and you don't contribute, you're leaving free money on the table, which is crazy! It's essentially giving up a percentage of your pay!
Plus, saving for retirement in a 401k is easy. All you have to do is sign up. Check out more of the best 401k moves you can make as well.
Step 2 - Save The Max In Your IRA
If you've invested in your 401k to at least to get your company match, it's time to start looking for what comes next for funding retirement savings. The next step in the order of operations for funding retirement is your IRA. There are a lot of resources out there to help you decide if a Roth IRA or Traditional IRA is better, but regardless of which you choose, investing in an IRA is a great way to save for retirement after you've maxed your 401k.
There are a lot of IRA misconceptions, but you should know the following - you can invest up to $6,000 per year (in 2019 and 2020), and if you're older, you get a catch-up contribution. All of the money in your IRA grows tax free. Depending on the type of IRA, you may not even have to pay taxes on your withdraws (that's a Roth IRA for you). All of these features make investing in an IRA Step 2 in the Order of Operations for Funding Retirement.
Make sure you check out the IRA Contribution And Income Limits here.
Check the best places to open an IRA here.
Step 3 - Continue To Max Your 401k Contributions
If you've already maxed out your IRA contributions, it's time to look at maxing you your 401k contributions. Remember to check out our guide on how to maximize your retirement contributions. In 2020, you can contribute $19,500 into your 401k pre-tax, and you can have a total contribution to your 401k (employee + employer contributions) of $57,000.
If your employer allows after-tax, non-Roth contributions, and you can afford it, you might consider maxing this out so that you can potentially take advantage of the Mega Backdoor Roth IRA.
Make sure you understand the 401k Contribution Limits here.
Step 4 - Max Your HSA
If you are in a high-deductible health plan, and you are eligible for a health savings account (HSA), you'd better be taking advantage of it to the max. I consider the HSA to be the secret IRA nobody is talking about, because it offers triple-tax benefits, and is simply an awesome way to save.
Plus, many employers offer matching contributions into an HSA, and many times the health insurance attached to the HSA is cheaper than other options offered.
The only reason that the HSA is #4 on this list is because many people simply don't qualify for it. However, if you do qualify for it, I'd move it to #2 - right behind taking advantage of your employer's match.
Make sure you check out the HSA contribution limits here.
Step 5 - Side Hustle And Do A SEP IRA
If you're a side hustler, or have any type of freelance income, you should consider doing a SEP IRA. This is another way to save pre-tax money in a retirement account, and lower your total tax bill from your side hustling income activities.
With a SEP IRA, you can contribute 25% of your earnings, or $57,000, whichever is lower.
Note: You can substitute a Solo 401k here if you are good about balancing contribution limits with an employer plan. A SEP IRA is usually easier for side hustlers with a 401k they max at their day job.
Step 6 - Save in a Standard Brokerage Account
After you've invested in both your IRA and 401k, you may not know what to do next. The best thing you can do after maxing out all the "traditional" retirement accounts is to just invest in a standard brokerage. This type of account has no special tax breaks for saving for retirement, but it comes in as Step 5 in our order of operations for funding retirement because it is important to invest versus just saving.
The key is to protect against inflation from eating your returns as you fund your retirement. If you just save the remainder in a savings account, you don't grow your money or keep up with inflation. While saving is important, it is more important to grow your money over the long run by investing.
Check out our list of the best brokerage accounts here.
Step 7 - Be Smart About Social Security
Step 7 in the Order of Operations for Saving For Retirement is Social Security. As I've mentioned before, Social Security isn't going anywhere, even for young workers. However, one thing that young workers should plan for is that the benefits will be less, and the retirement age will be much higher. I wouldn't be surprised if today's college graduates have a Social Security retirement age of 70 or even 75 before they can take benefits. The reason is that people are just living longer.
As such, you have to be smart about your Social Security benefits, even at a young age. The reason is that there are many factors that may, or may not, allow you to get benefits.
For example, if you work for a State or Local government, your organization may choose to opt-out of Social Security in lieu of their own retirement program. This could be beneficial to you (as the program may be better) or it could be worse. The bottom line is that you need to be smart about it and know what benefits you'll be eligible for.
Conclusion
So, if you follow this plan to maximize your pre-tax retirement savings, you'll be following the best order for funding retirement. If you don't have an option available to you (i.e. your employer doesn't offer a 401k), then just skip to the next step in the order of operations, just like PEMDAS above.
What's your thought on the right order of operations for funding retirement?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.
Emily @ evolvingPF says
I like this concept! I would edit the acronym to include the match distinction though – MIFBS or something (not as easy to remember!).
Robert says
Thanks for the love on the math! See only 50/50!
Rich says
Max out HSA should be the 2nd priority. Triple tax deductible contribution (fed, state fica), tax free growth and tax free distribution for medical costs. Invest it and forget it and use in retirement.
AverageJoe says
Great post, as usual, Robert! I skip a lot of the math around the Roth/Traditional debate if I already have a 401k, because having both a Roth (tax free money) and the 401k (pretax) in retirement buys so much more flexibility to play games with tax brackets. Lots of people do the math based on today….I’m looking at down the road AND today.
Jacob @ iHeartBudgets says
^ This is how I look at it. I have a 401k and Roth IRA, and like the balance. Now, I just need to run some hypothetical numbers….
TB at BLueCollarWorkman says
Glad to know my wife and I are doing it right haha, or at least right by your assessment 🙂
I asked my daughter that’s in junior high about that math problem and she says 7 too. She says:
6-1×0+2/2 =
6-0+2/2=
6-0+1=
6+1=
7
Mrs. Pop @ Planting Our Pennies says
Slight correction, it’s PEMDAS, not PEMDUS. Sorry for the math teacher in me coming out for a second.
That said, I like the idea of applying an order of operations, but I would add don’t sacrifice a Roth IRA for the sake of maxing out a 401K. Usually there’s space between when you’ve hit your company’s match and when you’ve maxed out, so for people that can’t max out both it can be a good opportunity to hedge against future tax uncertainty by having a portion of your retirement savings already have taxes paid.
KC @ genxfinance says
Cool I got it right. And you are quite right. These are great ways to fund your retirement. FIBS. I like it.
ESI says
I generally agree with this.
The one caveat I would offer is that if you want to retire early you will need to put more money where you can access it early (i.e. a brokerage account).
I’m close to retiring at 52 and have most of my wealth in your top 5 items — which I can’t get to easily unless I take substantially equal periodic payments (which I don’t want to do).
I’ll be able to do it but wish I had a bit more allocated to funds I could get to whenever I wanted.
Ed says
You *can* access money in a 401k, or IRA early (for early retirement) if you set up a series of substantially equal periodic payments (SOSEPP – Internal Revenue code 72(t)(2)(A)(iv)).
Basically, you have to commit to using the same formula to calculate withdrawal amounts for the next 5 years or until you’re 59.5 years of age (whichever is longer).
If you’re aiming for early retirement, it’s important to know about this. You can have tax-sheltered accounts and withdraw before age 59.5 without penalties… but it takes planning and you have to commit to the process.
Dividend Driven says
I actually agree with your order and I have been maxing out my Roth 401(k) now for 5 years, my Roth IRA for 7 years and my HSA for 1 year. Of course I’m also saving and investing on the side for the long term – but appreciate having the ability to max out my retirement accounts every year.
Joel says
My employer switched back to a pension plan {give us certain amount based on formula of work years and age and guarantee 5% return instead of giving higher match into our 403(b) }such that I put away $25k + $5,600 match. I get $28k into pension.
Q1. Does this mean I can put away $62k-$30,600 = $31,400 in after tax 403(b) for a back door mega roth or does the pension plan $28k decrease the amount down to $3,400?
Q2. Since my employer plan doesn’t allow for after tax contributions (I checked) and I have consulting income should I do a SEP-IRA and make after tax contributions up to $56k and then back door that into my Roth IRA or should I set up an LLC OR C or S corp and pass thru my consulting earnings and set up a separate Roth 401(k) thru the corp and make the after tax contributions of $6,400above the $25k I can put in here. I am banking that taxes will never be lower than 37% and am looking for ways to max out Roth contributions for estate planning purposes at least.
Robert Farrington says
1. The pension plan is independent of the 403b. What your employer does for you there doesn’t impact your defined contribution plans. Remember, your employer could also fail to fund your pension (think about all of these big companies with under-funded pensions), so there is employer risk there.
2. If you’re maxing the 403b at work, then I typically recommend a SEP for side hustle income. What you do with it at that point is up to you (i.e. keep it or backdoor it). The reason is that you don’t have do watch your limits.
DB says
Personally I would bump the HSA up to second behind matched 401k contributions. The triple-tax advantage can be significant, especially for individuals/families with higher medical expenses.
Robert Farrington says
If you’re eligible, totally. I wish I could plot this out as a “choose your own adventure” type scenario. I had to make a pick, and since most people still don’t have HSA eligible plans, we put it where it’s at.
DB says
I would also add Mega Backdoor Roth IRA contributions toward the bottom of the list for those lucky enough to have a 401k plan that allows after-tax contributions and in-service rollovers of those after-tax contributions to a Roth IRA.
brian says
How would a Saving allocation, say for emergencies, fit into your order. And how would you measure allocation?
Thanks,
bn
Robert Farrington says
I’m a big believer in having at least a 6 month cash emergency fund in a high yield savings account. You should do that first before anything really (except maybe combo with an employer match into a 401k).
Nick says
Consider a CD ladder instead of high yield savings if you have enough cash on hand. The interest rates are a little higher. If you don’t have enough, I agree, high interest savings is the way to go.