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For Your Life March 10, 2020

The 'retirement savings waterfall' explains where your money should go to build the most wealth

No matter where you are in your financial journey, it's always important to plan for the future. You only have one chance at saving for retirement before you reach your golden years, so it's a good idea to plan ahead before it's too late.

Know you should start saving or save more, but don't know what to do with additional savings? Enter the "retirement savings waterfall." For most retirement savers, this is the order you should follow when deciding where to send your next retirement dollar.

1. Invest in 401(k) to the employer match

The first place to funnel your retirement dollars is generally an employer-sponsored retirement account like a 401(k). Depending on where you work, you could have a 403(b) or 457 plan account, but they work very similarly to a 401(k) in most cases.

Larger employers tend to match employee 401(k) contributions up to a certain percentage of their gross income. For example, if you save 3%, your employer may match 3% bringing your total contribution to 6%. Some companies match more or less. If you're not sure about your plan, ask your manager or HR department.

If you don't take full advantage of an employer 401(k) match, it's like leaving free money on the table. You get every dollar of your match when you retire, so it's a big financial win for you to participate.

2. Max out your IRA or Roth IRA

Once you've reached your full employer match, your 401(k) may not be the best place to invest. While 401(k) accounts have great tax benefits and may have employer matching, they are notorious for high management costs and limited investment choices. That makes a self-directed IRA the best place to put your money next if you can afford to save more.

A Roth IRA is funded with after-tax dollars. This means you pay income taxes on your contributions this year, but withdrawals in the future are tax-free. Thanks to the power of compound returns, younger investors with a long time until retirement do the best with a Roth IRA.

Savers nearing their retirement may be better served by a traditional IRA. Like a 401(k), traditional IRA accounts use pre-tax dollars. That means you get a lower tax bill the year of your contribution but have to pay income taxes on future withdrawals.

For 2020, you can save up to $6,000 in an IRA or Roth IRA. Investors 50 or older can put an additional $1,000 per year, called a catch-up contribution.

3. Circle back to the 401(k) if you can

If you hit the maximum on your IRA or Roth IRA and still want to save more for retirement, which is a great decision, you should look back to your employer's retirement plan. While the costs and investments may not be as good as your IRA, the tax benefits still make saving in a 401(k) worthwhile.

The maximum you can save in a 401(k) for 2020 is $19,500. Employees 50 or older can make an additional $6,500 catch-up contribution.

Very few people need to save as much as the maximum IRA and 401(k) contribution combined. That would be a total of $25,500 for people under 50 or $33,000 for someone 50 or above. Unless you have a very high income or are trying to make up for missed years, that's a high savings level.

Most financial experts suggest saving around 10% to 15% of your annual gross income for retirement – that's your income before taxes and other deductions. If you are saving any less, saving at least 10% is a good starting goal for your retirement.

4. Round out your investments with a traditional brokerage account

If you are a saving and investing superstar who has hit the maximum in your retirement accounts, your next best place to save is a traditional brokerage account. While there are no tax benefits, a brokerage account allows you to invest in virtually all stocks, bonds, and funds. And, unlike a retirement account, you can withdraw at any time with no penalties.

Sure, there are taxes. But it may be wise to keep some investments outside of your retirement accounts anyway. If you ever have a major financial emergency or want to make a big purchase like a home, you could want to sell some investments to cover the costs. With a retirement account, you'll have to pay taxes and penalties in most cases for withdrawals outside of retirement.

Saving just a little is better than nothing

If saving thousands of dollars per year isn't attainable for you right now, that doesn't mean you shouldn't save at all. Even $5 per month for retirement is better than nothing. If you start small, you can always grow from there.

And, if you're a rockstar saver, you are making a smart decision for your future. Very few people ever regret saving too much for retirement. If you are flush with cash during your retirement, your future self will thank you.

 

This article was written by Eric Rosenberg from Business Insider and was legally licensed through the NewsCred publisher network. Please direct all licensing questions to legal@newscred.com.

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