You want your retirement savings working as hard for you as possible. The harder your money works, the quicker you’ll get to retirement, and the less you’ll actually have to save to get there.
One of the easiest ways to get the most out of your money is to use the right accounts. By taking advantage of the right tax breaks and other tricks of the trade, you can accelerate your savings and reach financial independence even sooner. So here’s a step-by-step guide you can use to choose the right retirement account for your specific situation.
Quick note: This advice is geared toward employees. If you’re self-employed, you can refer to this article.
1. 401(k) Employer Match
If your employer offers matching contributions in your 401(k), that’s the place to start, no matter what.*
Contribute at least enough to get the full match before even looking anywhere else. It’s a guaranteed return on investment that other accounts just can’t offer.
Every company has a different matching program, and some don’t match at all, so you’ll have to do a little legwork to figure out what your company offers. Asking your human resources representative is a good start, and you can also request a Summary Plan Description which will lay it all out.
As an example, your company may offer a dollar-for-dollar match on your contributions up to 6% of your salary. In that case you would want to make a 6% contribution to your 401(k) before contributing to any other accounts.
*When I say 401(k), I really mean any company retirement plan, including 403(b)s and other varieties.
2. Health Savings Account
This is a little unconventional, but when it’s used correctly a health savings account can be the best retirement account out there. It’s the only account that offers all of the following tax breaks:
- A tax deduction for contributions
- Tax-free growth
- Tax-free withdrawals (for medical expenses at any time, or for any reason after age 65)
In other words, it’s the ONLY account that allows you to save and use your money completely tax-free.
The catch is that most people aren’t eligible to use an HSA. You have to have a qualifying high-deductible health insurance plan, which for 2016 means at least a $1,300 deductible for individual coverage or a $2,600 deductible for family coverage.
If you’re eligible, you can learn more about finding a low-cost health savings account with good investment options here.
3. A 401(k), But Only If…
The next place to look is right back at your 401(k), but only if it offers high-quality, low-cost investment options.
If so, it’s a great next step because you can contribute a lot (up to $18,000 in 2016, or up to $24,000 if you’re 50+) and it keeps things simple since the account is already set up and you’re probably already contributing there to get your employer match.
So, how do you know whether the investment options are any good?
First, look at the fees. Cost is the single best predictor of future investment returns, with lower-cost investments performing better. And unfortunately, many 401(k)s are riddled with fees that hurt your returns.
You can use this guide to figure out which fees you should be looking for. If your 401(k) is high-cost, you can move on to Step 4.
But if the fees are low, take a look at the investments themselves. Does the plan offer index funds? Do they offer low-cost target-date retirement funds? Can you find investments that match your personal investment profile?
If the answers are yes, you can feel good about contributing to your 401(k) up to annual max, above and beyond your employer match.
There’s one other thing to consider here, and that’s whether your company offers a Roth 401(k) option. If so, you can check out this article to help you decide whether that’s the right choice for your specific situation.
4. Traditional or Roth IRA
If your 401(k) isn’t any good, or if you’ve already contributed the max amount and want to save more, the next place to look is an IRA.
An IRA works pretty much exactly the same as a 401(k), but you open it on your own instead of getting it through your employer. And there are two main types, with the big difference being how the tax break is applied:
- Traditional IRA: Like most 401(k)s, you get a tax deduction for your contributions, tax-free growth, and then your withdrawals are taxed as ordinary income.
- Roth IRA: There is no tax deduction for your contributions, but you get tax-free growth and tax-free withdrawals in retirement.
Which one is best for you really depends on the specifics of your situation. A Traditional IRA tends to be better for high-income earners, though in some cases it can be better even for middle-income earners. A Roth IRA tends to be better at lower incomes, especially if you expect your income to increase significantly in the future.
Quick note: A Roth IRA is a flexible account with a number of other interesting uses. Learn more about them in this post: Four Ways to Use a Roth IRA That Have Nothing to Do With Retirement.
5. Back to Your 401(k)
If you skipped over your 401(k) in Step 3 because of the fees, now is the time to revisit it with any extra money you’d like to contribute. Unless the fees are particularly egregious, the tax benefits offered by a 401(k) will likely outweigh the costs.
6. Taxable Investment Account
If you’ve used up all your tax-advantaged retirement accounts and still want to contribute more money, good for you! A regular old taxable investment account is probably the way to go.
There aren’t any special tax benefits, but there are plenty of ways to invest tax-efficiently, and you also have a lot of flexibility with these accounts to invest however you’d like. And unlike an IRA or 401(k), where early withdrawals generally come with a penalty, you can also access the money in a taxable account at any time and for any reason.
In Review: A Quick Order of Operations
Whew! That’s a lot. So here’s a quick order of operations you can follow as you make this decision for yourself:
- 401(k) up to full employer match
- Health savings account
- 401(k), but ONLY IF it has minimal fees and good investment options
- Traditional or Roth IRA, either instead of a bad 401(k) or for extra money on top of your 401(k)
- 401(k), if you skipped over it because of the fees
- Taxable investment account
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.