Retirement Savings Waterfall

9 Steps to Building a RetirementSavings
By Susan Pilon, CFP®

Saving for retirement can be hard. Add in all the various options and it can feel almost impossible knowing where to start. Instead of falling back on a scattershot approach, consider using what is often called the waterfall technique.

This retirement savings technique works by filling up one account bucket then letting additional savings cascade into the next bucket and so on.

The precise order of operations may vary depending on your specific circumstances, though the concept remains the same. There is no one-size-fits-all approach to financial planning but starting with thisframework can help to prioritize strategies and set you on the path to a secureretirement.

Step 1: Secure your emergency fund

Before sending your money elsewhere, you should start byfilling up your emergency fund bucket. Everyone’s bucket will be a different size depending on your personal situation,income, and job stability, but most experts recommend setting aside theequivalent of at least three to six months of expenses. Consider a high-yieldsavings account for this bucket. When deciding the account, be sure you canaccess these assets quickly if you find yourself in a pinch.

Step 2: Capture your company match

A retirement plan’s company match is “free money.” Takeadvantage by contributing enough to capture this perkand not leave free money on the table. However, each company operatesdifferently. It’s worth familiarizing yourself with your company’s matchingformula and vesting requirements in case you are looking to make an employmentchange soon. For example, you may have to be employed for a certain length oftime before the matching contributions vest.

Step 3: Explore an Employee Stock Purchase Plan

If your company provides an Employee Stock Purchase Plan(ESPP), the shares are typically offered at a discounted price, similar to the “free money” concept of a companymatch.

The contribution limit on these plans can go up to $25,000.To avoid putting all your eggs in one bucket, we recommend limitingconcentration in a company’s stock to 5% of your investment portfolio, thenmoving on to the next bucket.

Step 4: Pay off high-interest debt

In a backward way, paying down high-interest debt is a formof saving. You’re able to save more by not havingto pay unnecessary interest payments. If your debt has a 20% interest rate,which is around the common rate on credit cards, you are getting a 20% returnby paying off the debt and not incurring the interest penalty.

Step 5: Contribute to a Health Savings Account (HSA)

The next two buckets, an HSA and Roth IRA (IndividualRetirement Account), are somewhat interchangeabledepending on your personal situation and tax rate. Those with a high deductiblehealth care plan and in relatively good healthshould consider prioritizing contributions to an HSA, then move on to theirRoth IRA bucket. There is a long list of reasons HSAs are called “stealth” or “supercharged” IRAs.

Step 6: Contribute to a Roth IRA

Most of us tend to overweight the present by doingeverything we can to avoid taxes now, sometimes to the detriment of our futureselves. Putting all your money in tax-deferred accounts may one day force youinto a corner with large tax bills and RMDs (Required Minimum Distributions)you won’t fully spend. If this sounds like you, consider the benefits of taxdiversification with Roth IRA contributions that go in after-tax but come outtax-free.

If you’re over the income limitsfor Roth IRA contributions (i.e., greater than $228,000 for married filingjointly and $153,000 for single filers in 2023), consider “back-door” Rothcontributions where you contribute to an IRA then immediately move or convertthe contribution to a Roth IRA. An important note: Utilize back-door Rothconversions with an empty IRA or you could run up against the IRS’s pro-ratarule.

Step 7: Max out retirement account contributions

You likely have room left in this bucket to maximize yourretirement account contributions – now is the time to come back and fill upthis tax-advantaged bucket.

This bucket might include 401(k)s, 403(b)s, and 457(b)plans, but can also include other tax-advantaged accounts like cash balanceplans, non-qualified deferred compensation, and accounts that allow “mega”backdoor Roth contributions.

You likely have a choice between making pre-tax or Rothcontributions, a decision largely driven by when you expect to be in a highertax bracket. If the answer is in retirement, you’re better off paying taxes nowby making Roth contributions. If you’re like most people though, you’reprobably unsure when you will be in a lower tax bracket so making both pre-taxand Roth contributions isn’t a bad idea either. Either way, if you’ve made itthis far down the waterfall, you are on the right track.

Step 8: Saving with 529 Plans

While saving for education is a priority for some, werecommend waiting until your own retirement buckets are overflowing beforeprioritizing this one. While it’s a noble act, remember that you can borrowmoney for education, but generally not for your own retirement.

Step 9: Fill Taxable Accounts

Your “cup runneth over” and you have reached the end ofthe waterfall – congratulations on being a great saver! For the final bucket,we recommend filling up a taxable account. While these accounts have no specialtax breaks, certain investments may qualify for favorable capital gain anddividend tax rates if certain requirements are met. While there are some taxes,these accounts also provide great flexibility for quick withdrawals andadditional capacity to save for other major financial goals.

As we mentioned in the beginning, rarely does one-size-fit-allwhen it comes to financial planning. However, there’s no question thatestablishing a disciplined savings program is a key to retirement success andthis savings waterfall approach is a great strategy.

Please consult with an attorney or a tax or financialadvisor regarding your specific legal, tax, estate planning, or financialsituation. The information in this article is not intended as legal or taxadvice.

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