Prioritizing Your Savings: A Guide for the Perplexed

This is the blog post you’ve been waiting for! Many prior posts have described the pros, cons and availability of different types of tax-favored savings buckets. Today, I offer a guide for the perplexed; a recommended order in which to prioritize your scarce savings.

First a couple of caveats.
• These are only rules of thumb, of course, and your individual circumstances may dictate a different order. Rules of thumb are never always right.
• All suggestions are subject to availability. You can’t put money into a Roth 401(k) if your employer doesn’t offer one.
• Think of you and your spouse as one economic unit. If your employer doesn’t offer a 401(k) match, but your spouse’s does, fill up your spouse’s matched savings before tackling your own. Unless you’re planning on a divorce.
• All suggestions are subject to legal restrictions. A deductible IRA contribution may be better than a non-deductible one, but if you don’t meet the requirements to deduct your contribution, it’s kind of academic.
• The dollars needed to maximize your contribution to a savings bucket are best sourced from your current compensation. But don’t forget that the dollars already housed in an existing taxable investment account can also be used for that purpose. See February 8’s post.
• Read the whole list. Some later steps change the actions recommended in prior steps.

Okay. Here goes. Prioritizing your savings:

One. Your first slice of available dollars should go into your traditional pre-tax 401(k) or 403(b) plan, up to the maximum amount matched by your employer.

Two. If you expect your post-retirement tax bracket to exceed your current tax bracket (which is not usually the case), use your next slice of available dollars to pay the income tax cost of instead contributing Slice One on a Roth basis. Otherwise, move on to Slice Three.

Three. Your next slice of available savings dollars should go toward contributing the maximum amount to an IRA.

Three A. If you expect your post-retirement tax bracket to exceed your current tax bracket, make it a Roth IRA.
Three B. Otherwise make it a deductible IRA. If you don’t qualify for a deductible IRA, skip to Slice Four.

Four. Your next available dollars should go toward maximizing your elective deferral to your employer’s 401(k), even though this part is not matched.

Four A. If you expect your post-retirement tax bracket to exceed your current tax bracket (again, not usually the case), then make your elective deferral on a Roth basis, if available.
Four B. Otherwise, make it on a traditional pre-tax basis.

Five. If it’s 2010, use your next slice of available dollars to pay the income tax cost of converting your pre-existing traditional IRA to a Roth IRA. See February 28’s post for a description of the special tax break available only in 2010. This could take a lot of your savings, depending on the size of your traditional IRA.

Six. If you still have any money left, use the next slice of available dollars to pay the income tax cost of making Slices One, Three B, and Four B on a Roth basis instead of a pre-tax basis, even though you expect your tax bracket to be lower in the future.

Seven. What! You still have more dollars available? Lucky you. If it’s any year other than 2010, use your next slice to pay the income tax cost of converting your pre-existing traditional IRA to a Roth IRA. Again, this could take a lot of your savings if you have a large IRA.

Eight. Still more dollars? Use them to make the maximum allowable contribution to a non-deductible IRA, if Slice Three was unavailable to you.

Nine. I can’t believe you still have savings left! Good for you. Put them (or leave them) in an ordinary taxable investment account.

Whew! Done.