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How to Optimize Your Retirement Investing Priorities

The law in the United States is designed to encourage each working citizens to save for his or her own future. Through tax advantages, there are subtle incentives for investing in certain types of accounts. These incentives encourage financial literacy, boost use of the economic machine of the financial industry, and shift the burden of supporting the elderly from corporate pensions to the public.

Regardless of whether you think this is a good approach to supporting a population with an expanding lifespan, this is today’s environment. If you envision a future where you can do what you’d like to do with your life, unfettered by financial constraints despite a lower or zero income from work, you have to get on board with the concept of saving and investing for yourself.

There’s nothing stopping anyone for saving for their future by storing cash — whether in a mattress or in a safe. It’s more beneficial to do something else with that money, however, so you don’t lose purchasing power due to inflation and so you aren’t exposed to a loss in the event of a burglary. Rather than hoarding cash for retirement, take advantage of the various incentives that will help your money grow.

Because different types of retirement accounts have different levels of tax advantages and other benefits, it helps to know which should be the highest priority. Don’t miss a great opportunity to allow your money to grow as strong as possible in any investment.

Keep in mind I am not a financial planner or adviser. These thoughts come from my own analysis and thoughts about retirement investing. You can get personalized advice and suggestions by speaking with a financial adviser. I can’t make your decisions for you.

Priority 1: 401(k) account with (or up to) an employer’s matching contribution

The 401(k) account itself allows you to deduct your contribution from your taxes, so you owe less to the government in the years you’re saving for retirement. Your investments in the 401(k) grow tax-free. You only pay taxes when you withdraw your money from the account, when you are possibly in a lower tax bracket (although that is a major assumption about the future).

Even better than these tax advantages are incentives from employers. Many employers offer some type of matching arrangement. In one such arrangement, the company would match your 401(k) contribution dollar for dollar up to a certain amount. That amount may be a percentage of your salary like 3 percent. With this benefit, if you invest 3 percent of your $50,000 salary, you save $1,500 for the future and your employer gives you an additional $1,500.

That immediately doubles your money. You cannot ignore a 401(k) matching contribution because there is nowhere else you can get an immediate 100 percent return. This benefit becomes less valuable once you start contributing beyond the limit of your employer’s matching contribution. And if your employer does not match anything, you may want to skip this step entirely, because we will come back to the 401(k).

Priority 2: Roth IRA

While investing with a traditional 401(k) presupposes you will be in a lower tax rate during retirement, there’s a good chance that is not going to be a correct assumption. There are some forces working towards lower income tax rates in retirement. Social Security benefits will likely be lower decades in the future, reducing your income. Other income from your investments will likely be long-term capital gains, today taxed at a lower rate.

At the same time, the economy might require higher tax rates in the future. We’re benefiting today from the lowest tax rates in American history. This might be the time to pay taxes if you think the economy has no way to survive without higher tax rates in the future. The concept of favorable tax rates on long-term capital gains might disappear. And if you save and invest diligently, you may be able to generate more income than you expect.

There is a strong case for believing that the tax you’re paying today might be the lowest rates you’ll ever pay. Take advantage of that by investing in a Roth IRA. You don’t get a tax deduction like you would with a traditional IRA, but you won’t need to pay tax on your contributions or your earnings when you withdraw your Roth IRA funds in retirement. There’s another assumption inherent in this: that the law surrounding Roth IRAs doesn’t change.

Priority 3: Maximize contributions to your 401(k)

If you’ve maximized your Roth IRA, look back at your 401(k). By contributing more to your 401(k), you can take advantage of the tax benefits already mentioned. Because you already maximized your employer’s matching contribution, the only benefit left is the tax deduction and tax-free growth of your investment. This is still something to take advantage to lower your tax bills today and throughout the rest of your income-earning life.

Not every employer offers a 401(k). The non-profit I used to work for eventually offered a similar plan, a 403(b), with the same benefits, but other employees might not be so lucky. If a 401(k) isn’t available, you can fall back on a traditional IRA. Rather than investing the full $5,500 into a Roth IRA, split your total contribution between the Roth IRA and a traditional IRA. With a traditional IRA, you receive a tax deduction (subject to income limitations) and tax-free growth, like a 401(k).

If you have self-employment income, consider opening an Individual 401(k). The benefits are the same as an employer-sponsored 401(k), but you contribute as both the “employer” and the “employee” and receive reduced self-employment taxes in addition to an income tax deduction.

401(k) investors who like the idea of paying tax today in favor of reduced tax bills in retirement, those who like the idea of the Roth IRA, can often choose to designate some or all of their 401(k) contribution as a Roth 401(k). Whether this is offered is up to the employer.

Priority 4: Maximize contributions SEP IRA

The SEP (Simplified Employment Pension) IRA provides an opportunity for self-employed individuals to put aside more of their income for retirement and receive a tax deduction at the same time. The contribution limit for the SEP IRA can be much higher than the one for traditional and Roth IRAs, but otherwise, the SEP IRA operates the same way from a tax perspective as the traditional IRA. The limit for investing in an SEP IRA is 25 percent of income up to a maximum that changes almost every year, though there are some nuances to that calculation.

Priority 5: Invest anything else in a taxable account

Once you’ve maximized all the above investment types, you’ve run out of tax-advantaged options. While there are other avenues for tax savings, like deferred compensation, restricted stock, and carried interest, these are likely not available to most taxpayers. You will probably need to save more than just the above in order to achieve financial independence by the time you’d like to stop working, unless you are willing and able to limit your expenses.

Frugality can go a long way in making your retirement dollar stretch, but most people envision a life without worrying about whether they can afford to do a particular activity. A life like that requires saving a healthy amount of money over time. If your tax-advantaged opportunities are complete, you can save more by investing in a taxable investment account.

I suggest choosing the same discount broker to handle your IRAs and your taxable accounts. You usually don’t have much choice with a 401(k), but choosing a low-cost provider of index mutual funds, like Vanguard, is one way to use efficiency to help your investments reach their potential.

Get started even if you don’t read this article

The most important thing in any retirement plan is getting started immediately. I could have started ten years before I did and had a much better head start. You can’t make up for lost time. So don’t worry about your plan being perfect from the beginning. Doing anything is better than wasting time trying to know everything about investing before making your first contribution to a retirement plan. You’ll have time to work out the details. Start today.

Photo: Flickr

Published or updated November 7, 2012.

About the author

Luke Landes is the founder of shizennougyou. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about Luke Landes and follow him on Twitter. View all articles by .

{ 17 comments… read them below or add one }

avatar 1 Anonymous

Start Today! – Great advise by any measure. Most retirement advise today is bogus because its based on a statistical population that’s far too broad. It’s unfortunate that there are so many people that do little or nothing savings-wise because they skew the base. The most often quoted Rule-of-Thumb is the 70%-90% of pre-retirement income requirement for a “good” retirement. It is based on W2 income and spending percentages of this massive population base. Why base your retirement on the very thing (earned income) that’s going to go away? A focus on spending is a much better way for savers to plan and prepare. Here’s my (I’m retired) rule-of-thumb for retirement planning You’ll need 100%-150% of your pre-retirement SPENDING to enjoy a “good” retirement. Save early and save often!

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avatar 2 Anonymous

Nothing to disagree with here…

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avatar 3 Anonymous

I think you nailed the order of investing perfectly. The question is now: “how do we get more eyes on this article?”

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avatar 4 Luke Landes

Share it with your friends!

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avatar 5 Ceecee

I love my Roth IRA. I don’t have a matching 401K. I do presume, as you say, that taxes will be higher in the future—when I retire. I don’t see how they can go down.

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avatar 6 Anonymous

I’m trying to figure out where I want to put my HSA in this equation. It is even better in one sense because tax is never paid, going in or going out, but you can only spend it on medical expenses.

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avatar 7 Anonymous

Lance, I started maxing out my HSA last year ($6550 for my family plan). I put $500 a month in it, $200 from my employer and $300 of my own. I don’t tap it for medical expenses, I use money out of my paycheck for that. Everything over $1000 gets put into a total stock market index fund
As to wear it falls in line, i do this:
1) Roth401k up to employer match
2) Max out his and hers Roth IRA’s
3) Max out HSA
4) add to 401k if I have any money left

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avatar 8 Anonymous

I’m concur with this strategy. I always preach it to people I know, but sadly, I rarely see anyone take action.

I see a lot of arguments about why Roth IRAs aren’t for everyone because of tax strategy, but I think they are all moot points. Roth IRAs are the best choice for everyone because the withdrawals you take from the account later will not be included as income (which could help you qualify for low-income assistance) and if you don’t end up using the money, it can be passed on tax-free (also freeing your heirs from paying estate taxes).

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avatar 9 Anonymous

I don’t know about all low-income assistance programs but the many of the biggies, especially Medicaid have both income and asset requirements. IRAs, ROTH or otherwise are NOT exclude in any way from these calculations and some have asset limits (excluding homestead) as low as $2,000.

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avatar 10 Anonymous

You’re absolutely right. I guess I should have clarified. My comment was meant more for things like energy assistance programs, and things of that nature.

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avatar 11 Anonymous

I agree with you that it is very important to start early to build up your retirement plan. By not being frugal, I have not encountered any problems with regards to my investments. It is also best to consult with a financial adviser in order for you to build up a plan towards your retirement goal, if you can’t do it alone. Planning for your retirement is one of the most important decisions you will have to make concerning your financial future and life, in my opinion.

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avatar 12 Anonymous

Hi Flexo,

Great list, though you missed some other options that will help being the most tax efficient. I’ve mentioned them on a similar post as this:

– US I Savings Bonds
– MLP and Muni Bonds

Then taxable investing should be last. Of course it also depends upon your priorities. ie if you are saving for a house, taxable investing might make the most sense.

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avatar 13 Anonymous

Oh I also forgot 529 account.

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avatar 14 Anonymous

We might have differing opinions but I think you completely missed an entire investment class based on insurance based products which are often tax deferred (in the case of fixed or variable annuities) or can be tax free (via basis stripping/loans on a whole life plan)

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avatar 15 Luke Landes

I’m not well-versed on the tax implications for annuities, but it’s something to consider. We’re seeing now how sometimes “guaranteed returns” with annuities aren’t always so guaranteed, so I still would prefer to exhaust all investment options before heading into an insurance product for financial growth (or stability).

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avatar 16 Anonymous

Thanks for the reminder. Definitely need to max out my Roth IRA still.

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avatar 17 Anonymous

Hi Flexo,

Very solid advice. I wonder how many start-ups offer 401(k) plans to their employees. Often folks think that because there is no matching that perhaps a 401(k) plan is not meaningful, but that is to overlook the important tax benefits. I encourage start-ups to set up 401(k) plans for their employees even if there is no company matching.


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