This Simple Rule Tells You Where to Put Your Retirement Money

Retirement illustration
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IRAs. Roth IRAs. 401(k)s. SEP IRAs. Simple IRAs.

Considering all the different types of retirement accounts can get a little dizzying. With all these options, where should you be socking away your retirement dollars?

The choices you make depend a lot on your own financial situation, so there’s no hard-and-fast rule for where to stash your retirement savings. But there is a three-part rule of thumb that will apply to most savers. Here it is:

  1. If your employer offers a 401(k) matching program, withhold as much you need from your paycheck to max out that match.
  2. If you can afford to save more, put it in a Roth IRA.
  3. If you max out your Roth IRA, go back to your 401(k) and withhold more from your paycheck until you’ve maxed that out.

Got it? Good. Here’s why this is the way to go with your retirement dollars.

401(k) Matching

This is the obvious first choice. Why? Well, because it’s free money, and you don’t say no to free money. More than half of employers will match at least some portion of their employees’ 401(k) savings. Usually this takes the form of either a dollar-for-dollar match — where the employer matches 100 percent of your contributions up to a certain percentage — or a percentage match, in which the employer matches only a percentage (usually 50 percent) of your withholdings up to a certain percentage.

For instance, let’s say your employer offers to match 50 percent of contributions up to 6 percent. So that means that if you make $100,000 a year, and withhold 6 percent ($6,000) of it for your 401(k), your employer will kick in an additional 3 percent ($3,000), bringing your total savings to $9,000 a year.

Again, this is free money. Find out what your employer’s matching percentage is, and do what you need to do to max out that matching.

(The one caveat here is that your employer’s matching contributions are only yours if you stay with the company for a certain amount of time — this is determined by what’s known as a vesting schedule. So if you don’t think you’re long for your new company, then be aware that some of that free money may disappear if you leave early.)

Roth IRAs

You can save a maximum of $18,000 a year in a 401(k), but we’re not going to max that out — at least, not yet. Instead, once you’ve saved what you need to max out the employer matching, you’re going to turn your attention to a Roth IRA.

Financial planners and personal finance gurus tend to sing the praises of Roths, and for good reason. While it doesn’t allow you take an upfront tax deduction like a traditional IRA, you can withdraw from it tax-free once you retire. And in many ways it’s the perfect tax shelter; as investing expert Joshua Kennon explains:

“With a Roth, you pay no taxes on your dividend income. You pay no taxes on your capital gain income. You pay no taxes on your interest income.”

And it also offers flexibility, as the Roth IRA has more lenient withdrawal rules than its traditional cousin: You can withdraw money from it to buy your first home, and in some cases that money can also be used to pay for a medical emergency. That means you don’t need to choose between saving for retirement and saving up for your first home, and it can even serve as a backup emergency fund.

You can save up to $5,500 a year in a Roth IRA. If you can afford to do so, contribute the maximum every year.

Back to the 401(k)

Let’s return to the hypothetical earner making $100,000 a year. If your employer offers 50 percent matching on up to 6 percent in contributions, then maxing that out puts you at $9,000 a year, or 9 percent of your salary. Add on your maximum Roth IRA contribution of $5,500, and you’re at $14,500, or 14.5 percent of your income.

That’s great! But if possible, you should aim to save at least 20 percent of your income. And saving even more can obviously have a huge impact on your nest egg and perhaps set you up for an early retirement. So if you still have money left over after maxing out your Roth IRA, you should go back to that 401(k) and contribute even more. You’ve already maxed out your employer match, so upping your contribution percentage won’t get you any more free money. But your 401(k) still offers the obvious benefit of letting you contribute pre-tax dollars to your retirement fund.

The maximum amount that an employee can contribute to their 401(k) annually is $18,000. So that hypothetical earner who already maxed out the employer matching with a $6,000 annual contribution can call their 401(k) provider (or just log on to their website) and increase their contribution by up to an additional $12,000 a year. That would bring their annual savings up to $26,500. And saving more than a quarter of your salary is a great way to hit your retirement saving goals and potentially even retire early.

Bottom Line

This game plan won’t apply for every saver. Some employees don’t have access to a 401(k) matching program, and depending on your financial situation, different retirement vehicles may be more appropriate for you. And of course, not everyone can afford to max out their retirement accounts. But if you’re allocating and prioritizing your savings, remember to start with your 401(k) matching, then go to your Roth IRA, and then put any additional money you can afford to save into your 401(k).