Retirement Investing Priorities

You’re ready to start investing for retirement, but should you invest using your employer sponsored retirement plan (401(k), 403(b), etc.), an IRA, or something else? In general, these are the retirement investing priorities I would follow:

1. 401(k) or 403(b) to get the maximum employer match
2. Pay down high-interest debt
3. IRA (traditional or Roth) up to annual limit
4. 401(k) or 403(b) up to annual limit
5. Taxable account

Following is a discussion of the rationale for these priorities.

Some employers offer 401(k) or 403(b) plans where they match a percentage of the employee contribution up to some limit. For example, the employer might contribute $1 for every $2 the employee contributes, up to 6% of the employee’s pay. In this example, you would make an immediate 50% return on your investment by contributing up to 6% of your pay to your 401(k). Not contributing the full 6% of your pay to this 401(k) would basically be turning down free money. Even if the investment choices are not great (e.g., high-expense, actively-managed mutual funds), this probably still is your best bet for your first retirement investment dollars.

If your employer does not offer a matching contribution, or if you’ve already contributed enough to get the maximum employer match, then paying down credit card debt or other high-interest-rate debt probably is your best investment. I’ve already posted on this topic, so I won’t discuss it further here. If interested, please read Paying Down Debt as an Investment.

A fully deductible, traditional IRA contribution probably is better than a 401(k) or 403(b) contribution with no employer match. Most 401(k) and 403(b) plans don’t offer the excellent, low-cost index funds available through an IRA account at Vanguard. If you’re starting out, and want to keep things simple, it’s hard to beat the Vanguard Target Retirement funds, which I’ve written about in several posts (A Single Fund Solution and Vanguard Target Retirement Funds Minimum Investment Now $1,000). If you don’t have the $1,000 minimum investment, put money from every paycheck into a savings account until you’ve saved $1,000, then open an IRA account at Vanguard, and start investing in the appropriate Target Retirement fund.

If you are ineligible to take the deduction for a traditional IRA contribution, or if you expect to be in a higher tax bracket when you retire, then a Roth IRA is a good choice to consider. It’s also a good choice if you pay little or no income taxes, since the current tax deduction you would get from a traditional IRA contribution has little or no value to you.

If you are ineligible to make a Roth IRA contribution (because your income exceeds the limit), then you can make a non-deductible contribution to a traditional IRA, then immediately convert it to a Roth IRA. This commonly is referred to as a backdoor Roth contribution.

If you’ve contributed to your 401(k) or 403(b) to maximize the employer match, have no high-interest debt, and have made your maximum IRA contribution for the year, then you’ll probably want to contribute more to your 401(k) or 403(b) to get the additional tax deduction. However, if your investment options are really horrible, you might want to skip this and go to the next choice.

If you have made the maximum annual contributions to your 401(k) or 403(b) and an IRA, and have no high-interest debt, then you’re ready to start using a taxable account for additional retirement investments. You can open an individual, joint, or trust account at Vanguard, and make additional investments in the same Target Retirement fund you’re using in your IRA (same fund, different account). Eventually, you may want to use separate stock and bond funds to minimize your taxes, but that’s a topic for another post.