A friend recently shared a story with me about a time they were traveling with one of their friends to a wedding a few states away. Their friend wanted to make a good impression on the other wedding attendees and had decided the best way to accomplish this was to rent a Tesla to drive to the wedding. On the surface this seemed like a fine idea, Tesla vehicles were popular in the news, they needed a mode of transportation to get to the wedding, and the friend was considering purchasing a Tesla for their daily commute.
The two friends embarked on their road trip in the rented Tesla. The first time they stopped to charge the battery, they realized there was a problem. They had not rented a long-range Tesla and stopping to recharge the battery takes much longer than stopping to refuel a gas tank. After many stops and subsequent long waits to recharge they ended their stressful journey by pulling into the hotel parking lot (with a charging station) at 1% remaining battery and with just enough time to run in before the rehearsal dinner was set to begin.
While they ultimately made it to their destination on time their vehicle of choice made their journey much more difficult than it needed to be and imperiled their chances of success. Much like making the correct choice of vehicle is important to having success on a road trip, choosing the correct vehicle (and allocating to said vehicles in the correct order) for your retirement journey is also important to maximizing your chances of success.
With the end of the year approaching and many company open enrollment periods…opening, I wanted to share some tips and tricks for prioritizing available dollars that should apply to most individuals. Of course, your situation is unique to you, so I encourage you to discuss your situation with your advisor. If you don’t yet have an advisor of your own, you can click HERE to reach out to one of our advisors at Sequoia to learn more.
Quite possibly the most important first step for directing additional funds is to establish an Emergency Fund, or at the very least, establish a plan to build one quickly while taking advantage of the recommendation for step two. A rule of thumb is to establish at least three months of expenses while trying to build up to six months of expenses in combination with some of the other recommended steps. It is very important that this Emergency Fund be in cash because the purpose of the Emergency Fund is to protect your ability to maintain your Human Capital in the case of an emergency, which is likely to be your biggest asset for most of your working career.
A second recommendation is to take advantage of any employer match being offered in your employer sponsored retirement plan (401(k) or 403(b), for example). This is very possibly one of the best returns on investment you will have access to, regardless of what the employer match might look like. For example, your employer may offer a match on 100% of the first 3% you contribute, if that is the case, you’ll want to make sure you contribute at least 3%. They might offer a match of 50% of the first 6%, in which case you’ll want to make sure you put in that 6% in order to maximize your employer’s matching contribution. In these examples (assuming you stay at the company long enough to have the employer contributions vest, which can be variable depending on your employer,) you would receive returns of 100% and 50% respectively (before taking into account the performance of the underlying investment) which can provide a massive jump-start for your retirement savings.
After contributing amounts that an employer offers to match, the next avenue that likely makes the most sense is to put additional dollars toward paying off higher interest loans such as outstanding credit card balances or student loans with an interest rate higher than you expect to receive from invested dollars. This amount could be different for everyone, but the interest rate I personally target is around 6%. Generally, you will likely want to tackle these debts from highest interest rate to lowest interest rate (widely known as the avalanche method), but there can certainly be psychological benefits to tackling debts from lowest balance to highest balance (widely known as the snowball method) if that will help you stay diligent.
The next vehicle I would recommend, if you have access to a High Deductible Health Plan (HDHP), would be to contribute as much as you can of the maximum to your Health Savings Account (HSA). For 2022 the limit of employee and employer contributions combined will be $3,650 if your HDHP only covers yourself and $7,300 for a HDHP that covers family. Also note that an extra $1,000 catch-up contribution is available if you are 55 or older. The reason contributions to an HSA should be prioritized at this point is that they are potentially triple tax-advantaged. Contributions made to an HSA are deductible from your income in the year contributed (make these via payroll deduction to avoid federal payroll taxes, if possible), distributions made for qualified medical expenses are tax-free, and distributions can be taken after age 65 for any expenses with no penalty. As a bonus tip, if you can afford to pay for qualified medical expenses out of pocket instead of from the funds in your HSA, the HSA can continue to grow tax-deferred while you save the receipts to reimburse yourself later.
After maximizing contributions to your HSA, or if you are not covered by a HDHP, the next vehicle of choice is to contribute up to the maximum allowed to your employer sponsored retirement plan. Deferral limits on employee contributions for 2022 are $20,500 on the most common retirement plans with a $6,500 catch-up contribution available for those age 50 and over. You may have another important choice to make regarding this savings vehicle if your plan allows you to make Roth contributions. Unlike traditional contributions, which do not count toward your income in the year contributed, but are taxed when distributed, Roth contributions do count toward your income in the year contributed, but there is no tax on qualified distributions (including the growth in the account)! This choice can come down to individual circumstance, but the general rule of thumb is that if you project that you will be in a lower tax bracket in retirement then it makes sense to make traditional contributions, but if you project that you will be in a higher tax bracket in retirement, or you have a long enough time horizon that the growth in the account will outpace the tax differential between now and retirement, then making Roth contributions may make the most sense. You may also find that it makes sense to split your contributions between traditional and Roth contributions so that you have multiple different choices when drawing down your portfolio in retirement. Note that employer contributions will always fall into the traditional bucket.
Once you have reached the deferral limits on your retirement plan, or if you have no retirement plan available to you, an alternative vehicle choice is a Traditional IRA or Roth IRA which have much lower contribution limits ($6,000 for 2022 with a potential $1,000 catch-up contribution available for those age 50 and over). Roth IRA contributions are further limited if you make over $129,000 and file single on your tax return or if you make over $204,000 and file married filing jointly. The deductibility of traditional IRA contributions may also be reduced if you or your spouse are covered by a retirement plan through work (although you can make non-deductible contributions and later convert those contributions to Roth if it later makes sense to do so).
At this point, if you have any other outstanding liabilities you can pay those down to free up cash flow, allowing yourself more flexibility. Once you consider yourself debt-free or if you would rather invest your remaining cash flow than to pay off whatever low interest debt you may have remaining, consider setting aside any remaining excess in a taxable account. There are no contribution limits to a taxable account, your funds would be accessible at any age, and this will also allow for more optionality when drawing down accounts in retirement.
Now that we have an idea of the right retirement vehicles to use and when, feel free to grab some snacks, pack the cooler, buckle up, and get ready to take the road trip of a lifetime.