Forget about picking which stocks, mutual funds, or ETFs you might want to invest in. Figuring out which types of retirement accounts you should be funding, and in what order, can prompt a severe case of analysis paralysis all its own — especially if you’re one of the fortunate workers who have access to Roth IRAs, 401(k) plans, and health savings accounts.
You could list the pros and cons of 401(k)s, HSAs, and Roth IRAs, and diagram the various IRS restrictions and tax implications associated with each of these accounts — and still be no closer to a decision about where to put your money.
Doing a personal analysis can be useful if it helps you get a better handle on your own situation. But if you’d prefer to start with a generally solid retirement contribution strategy for 2021, take a look at the framework below. It prioritizes contributions by account type in a waterfall format — meaning you’d start at the top and keep moving down the list until you’ve used up all the funds you have budgeted for retirement savings this year.
1. Contribute enough to your 401(k) to max out your employer match
A recent report from the Plan Sponsor Council of America concluded that the average employer 401(k) match rate was 5.3% in 2019. If you make $50,000 a year, that would amount to $2,650 in free money that you could add to your retirement nest egg.
Ask your plan administrator or human resources department to explain your company’s matching rules, then set your contribution rate accordingly. Some employers will match dollar for dollar, while others might match $0.50 for every dollar. Either way, there will be a cap on what your employer will fund. Set your own 401(k) contributions high enough so that, by the end of the year, you will get every penny of matching funds available to you.
2. Max out your HSA contributions
Next, look to send some money to a health savings account (HSA) if you are able to fund one. Their use is limited to people and families that have high-deductible health insurance plans, but HSAs are attractive for long-term savings because they offer a triple tax benefit. Contributions to them are tax-deductible, earnings in them are tax-deferred, and withdrawals from them that are used for medical expenses are tax-free. And once you turn 65, you can pull money out for non-medical reasons without penalty. Those withdrawals, though, will be taxed as regular income, just like a 401(k) distribution.
That means there’s no risk of over-funding an HSA. If you don’t use the money for medical expenses, you can use it to supplement your other retirement savings.
In 2021, you can contribute up to $3,600 to an HSA if you have an individual health plan or up to $7,200 if you have a family health plan.
3. Make Roth IRA contributions if you can
Once you’ve maxed out your HSA, see if you qualify to contribute to a Roth IRA. Your income will be the main factor. The IRA contribution limit in 2021 is $6,000 or $7,000 if you’re 50 or older. But as a single filer, you can only contribute up to the limit if you make less than $125,000 a year. Married filers have to make less than $198,000. You can contribute a reduced amount as long as you don’t make more than $140,000 annually as a single filer or $208,000 as a married filer.
Roth contributions are not tax-deductible, but qualified distributions in retirement are tax-free. This offers some nice tax diversification in retirement, since 401(k) and non-medical HSA withdrawals will be taxable. Roth contributions are especially practical if you expect to be in a higher tax bracket in retirement than you are today.
4. Max out your 401(k) contributions
Alternatively, your 401(k) may accept Roth contributions — and the income limits would not apply there. Ask your plan administrator if you have that feature and, if so, how to set it up.
In 2021, you can deposit up to $19,500 in your 401(k) across Roth and regular contributions. If you are older than 50, your contribution limit is $26,000.
5. Invest via a traditional IRA or standard brokerage account
After you’ve captured all of your employer match, maxed out your HSA contributions, stashed money in a Roth account, and hit the cap on the 401(k) contributions, go ahead and invest either through a traditional IRA or in a taxable brokerage account. Traditional IRAs give you some tax breaks, and while you won’t get any tax-related perks with a regular taxable brokerage account, you will have flexibility to use that money whenever and however you want.
One step at a time
In reality, you probably don’t have $25,000 or $30,000 to save for retirement each year. Don’t be discouraged by that. You can still build up a portfolio sufficient to finance a comfortable retirement. For now, set a goal of contributing at least enough to your 401(k) to earn your full employer match. Then, as your income increases, branch out and diversify your contributions across your different accounts. That should put you on track for the retirement you want.