The optimal savings vehicles are client-specific, both in what they may have available to them, and in what would be prudent for their specific situation. Nonetheless, in general, this is usually the right order (exceptions and other issues at the end) for a typical client who expects to be in a lower tax bracket in retirement than they are now:
- Tax-deductible, employer-based retirement plans (such as a 401(k) plan) to the extent of any match – a match just can’t be beat!
- For a married couple, priority of funding must consider:
- the better match
- the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
- the longer deferral (the younger spouse will have lower RMDs in retirement if desired)
- For a married couple, priority of funding must consider:
- HSA savings account – tax-deductible on the contributions and tax-free withdrawals (if used for medical expenses) later (ideally in retirement).
- Tax-deductible, individually-controlled retirement accounts (such as a traditional IRA) – broad investment options and generally more favorable “exceptions” if early withdrawal became necessary.
- For a married couple fund the younger spouse’s first.
- Tax-deductible, employer-based retirement plans (such as a 401(k) plan) from the match (see #1 above) to the limit.
- For a married couple, priority of funding must consider:
- the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
- the longer deferral (the younger spouse will have lower RMDs in retirement if desired)
- For a married couple, priority of funding must consider:
- Tax-free retirement vehicles (such as Roth IRAs).
- For a married couple fund the younger spouse’s first (this currently doesn’t matter, as there are no RMDs, but the law could change)
- If education funding is desired see College Funding.
- If tax-inefficient investments (such as taxable fixed income) will not fit inside the previous options on this list see Asset Location Strategy (the five items at the end).
- Taxable investments (regular brokerage accounts).
Important caveats and other comments:
- I have ignored liquidity needs in the list above. Of course short-term liquidity may take precedence over some of the options listed and funding #5 (since original contributions can be withdrawn without penalty) prior to #2-4 might make sense. (Though probably not in place of #1.)
- I have ignored the “investment” opportunity of reducing debt. There may be behavioral and psychological issues that would impact the order, but from a purely financial perspective, there is low-rate (typically mortgage) debt and high-rate (typically consumer) debt:
- High-rate debt should generally be paid after #1, but it will depend on the specific situation. (Perhaps the client can both pay off the debt in a reasonable time frame and fund retirement vehicles. If they are going to max out the retirement plans every year going forward, they probably want to use them now too, not just after the debt is gone, since there is no “catch-up” when fully funding.)
- Low-rate debt should probably be paid down at #6 or #7 (in that order) if either is applicable.
- Investing in human capital (education or skills), particularly for a younger person, might be a better investment than many of the options above. (Though probably somewhere below #1.)