Math Skill 8 - Order of Funding Retirement Accounts

The following is the recommended order for funding your retirement accounts. In other words, if you have a certain amount you want to start saving each year, this list will tell you how much to deposit in which type of account. If you do not have access to a certain type of account (for example, if your employer does not offer a 401(k) with a match), then simply skip that account type and move to the next one in order.

The order of funding accounts works like a trickle down waterfall. The first stop is the 401(k) with the match. Once you receive the match, this "bowl" reaches it's limit. If you have any more money to save after claiming the full 401(k) match, it will spill over to the next level - the Roth IRA. Once the IRA limits are reached, any leftover spills over to the next level - the 401(k) again.

Each step in the calculations below is designed to help you find 1) how many dollars will flow into that particular account for that step and 2) how many dollars spillover to the next step.

Step 1 –401(k), up to the match limit

The 401(k) gets the top priority ONLY if your employer also offers a match. Since the match is free money, your first investment priority should be to contribute as much as it takes to get every free matching dollar that you can. In order to get the full match, a person must contribute the match limit * annual salary. This is the maximum amount that should be invested in the 401(k) before moving on the Roth IRA.

Maximum to 401(k) for Step 1 = match limit * annual salary.

Spillover to step 2 = Total amount to save - amount saved in step 1

Step 2 - Roth IRA, up to annual contribution limit

If you have gotten the full 401(k) match and you want to save more, then you should put that money into a Roth IRA. Remember that Roth IRA’s have annual limits on how much you can put in them each year, per person. For example, if the current annual limit is $7,000 per year, then a married couple could save up to $14,000 per year in Roth IRA’s because each spouse can save $7,000 in their own account.

Maximum to save in Roth IRA for step 2 = Annual IRA limit for household

Spillover to step 3 = Total amount to save - amount saved in step 1 - amount saved in step 2

Step 3 - 401(k) up to the annual contribution limit

If you have gotten the match and maxed out the Roth IRA contribution and STILL want to save more, then you can go back and start putting more money into your 401(k). 401(k)’s have annual contribution limits just like IRAs, but their limits are typically much higher, so if you need to save more than the IRA limit allows, then the 401(k) is your best bet because of its tax advantages.

In this class, we will not be concerned with 401(k) contribution limits in our calculations. Assume there is no limit for 401(k)s for this step.

Amount to save in 401(k) for step 3 = Total amount to save - amount saved in step 1 - amount saved in step 2

Step 4 - Taxable brokerage accounts

Only AFTER you have maxed out your IRA and 401(k) limits should you ever consider using a taxable investment account. The reason is because of the taxes you pay each year on the growth of these accounts. 401(k)s and IRAs do not pay taxes each year, and thus are far more effective at growing your nest egg than a taxable account.

Very few households should ever have a need to use a taxable investment account because the contribution limits for IRAs and 401(k)s are quite high. For example, in 2019, the annual contribution limit for 401(k)s was $18,000 and the IRA limit was $6,000. Therefore, a married couple could save up to $30,000 per year ($18,000 in the 401(k) + $6,000 in IRA for spouse #1 + $6,000 in IRA for spouse #2) in tax advantaged accounts. Not many households have enough income available to even be able to save that much money per year, so few should ever need to pay taxes on their investments.

Step 5 - Variable annuities and cash-value life insurance policies

Annuities and life insurance policies can be very useful, but not as a place to hold your investments. The reason is because of hidden fees in these accounts tend to make them very expensive to hold. For most households, the fees in these accounts are actually more expensive than simply paying taxes on a taxable brokerage account. This is why it is the last place you should invest your money. We’ll talk about the benefits of annuities and life insurance in unit 4.

NOTE: the IRA and 401(k) contribution limits change over time. When you start your own retirement savings plan, be sure to look up the contribution limits for that year. In these practice problems, you will be given a contribution limit for these accounts that you should use for your calculations.

Example Problems

Example 1:

Jack and Jill are a married couple who want to start saving for their retirement. Jack is self-employed, and therefore has no 401(k) available to him. Jill has a 401(k) offered through her employer that provides a match of 50% up to 4% of her $82,000 per year salary. If the couple wants to save $19,000 per year, how much should they put into each account? Assume the IRA contribution limit this year is $6,000.

Solution

Priority #1 is getting the matching dollars. In order to get the full match, Jill must contribute 4% of her salary. So, she should put up to 4%*$82,000 = $3,280 into her 401(k). That leaves them with $19,000 - $3,280 = $15,720 that still needs to be assigned to an account.

Priority #2 is to fill up a Roth IRA for both Jack and Jill to the limit. Since the limit is $6,000 this year, we will have Jack put $6,000 into his Roth IRA, and Jill will put $6,000 into her Roth IRA. They now have $15,720 - $6,000 - $6,000 = $3,720 left to invest.

That takes use to priority #3 – going back to the 401(k). The remaining $3,720 will go into Jill’s 401(k).

Total 401(k) contribution = $3,280 + $3,720 = $7,000

Roth IRA contribution = $12,000

Example 2:

Latifa is a single woman working in NYC. She wants to invest $22,000 per year. If the IRA contribution limit is $9,000 this year and her employer offers a 401(k) with no match, determine how much she should contribute to each type of account.

Solution

Since her 401(k) does not offer a match, we will skip priority #1.

The next priority is a Roth IRA. She will be able to deposit the maximum limit of $9,000 to her Roth IRA. This leaves her with $22,000 - $9,000 = $13,000 that we need to find an account for.

Priority #3 is to go back to the 401(k). So, she will deposit the remaining $13,000 into her 401(k).

Total to 401(k) = $13,000

Total to Roth IRA = $9,000

Example 3:

Ben and Berniece are a married couple. Berniece has a 401(k) match at work that will match 50% up to 10% of her $95,000 per year salary. Ben owns a small business that does not provide a 401(k). If they want to save $32,000 per year and the IRA limit this year is $10,000, how much should they save in each account?

Solution

Priority #1 is to fund the 401(k) up to the match limit. The limit is 10% * $90,000 = $9,000 that will be invested in Berniece’s 401(k). After they do that, they will have $35,000 - $9,000 = $26,000 left to invest this year.

Next, we fund Roth IRA’s for each spouse. The limit is $10,000 per year per person, so they can invest $10,000 in Ben’s Roth IRA and $10,000 in Berniece’s Roth IRA. This gives them a total of $10,000 + $10,000 = $20,000 in Roth IRA’s. They now have $26,000 - $20,000 = $6,000 left to assign to accounts.

Priority #3 is to put the remainder into the 401(k). Since they have already assigned $9,000 to her 401(k) to get the match, we simply add the $6,000 left over from the Roth IRA’s to the $9,000.

Total to 401(k) = $9,000 + $6,000 = $15,000

Total to Roth IRA = $20,000

Example 4:

Kyler is a single man who wants to save for retirement. He has a 401(k) plan available at work that provides a 100% match up to 6% of his $35,000 per year salary. If he wants to save $4,000 per year, how much should go into each of his accounts if the IRA contribution limit this year is $4,000?

Solution

Priority #1 is to get the full match. To get the full match, he will have to contribute 6% * $35,000 = $2,100 to his 401(k).

Now that he has the full match, he will fund priority #2 – Roth IRA. After he puts $2,100 in his 401(k), he will still have $4,000 - $2,100 = $1,900 to save. This is less that the IRA contribution limit, so he can contribute all of it to his Roth IRA.

Total to 401(k) = $2,100

Total to Roth IRA = $1,900

Watch it in Action!

Practice Problems

Practice problems #1-5 are for single individuals. Practice problems #6 - 10 are for married couples. Remember that each person in the marriage can contribute to their own IRA, so a married couple will be able to contribute twice as much to IRA’s as a single individual.

1. Chad is single and wants to save $13,000 this year. If their 401(k) offers a match of 50% up to 2.7% of their $80,000 salary and the IRA contribution limit is $8,000, determine how much they should save in each type of account.

2. Zachary is single and wants to save $17,000 this year. If their 401(k) offers a match of 25% up to 5% of their $87,000 salary and the IRA contribution limit is $9,000, determine how much they should save in each type of account.

3. Megan is single and wants to save $17,000 this year. If their 401(k) offers a match of 100% up to 4.3% of their $129,000 salary and the IRA contribution limit is $10,000, determine how much they should save in each type of account.

4. Kaylee is single and wants to save $12,000 this year. If their 401(k) offers a match of 50% up to 3.7% of their $74,000 salary and the IRA contribution limit is $7,000, determine how much they should save in each type of account.

5. Emily is single and wants to save $18,000 this year. If their 401(k) offers a match of 75% up to 4.2% of their $121,000 salary and the IRA contribution limit is $11,000, determine how much they should save in each type of account.

6. Gage is married and wants to save $22,000 this year with their spouse. If their 401(k) offers a match of 50% up to 4.2% of their $121,000 salary and the IRA contribution limit is $12,000, determine how much they should save in each type of account.

7. Alexander is married and wants to save $20,000 this year with their spouse. If their 401(k) offers a match of 50% up to 5.4% of their $109,000 salary and the IRA contribution limit is $6,000, determine how much they should save in each type of account.

8. Alexis is married and wants to save $16,000 this year with their spouse. If their 401(k) offers a match of 25% up to 5.1% of their $115,000 salary and the IRA contribution limit is $12,000, determine how much they should save in each type of account.

9. Bruce is married and wants to save $26,000 this year with their spouse. If their 401(k) offers a match of 25% up to 4.9% of their $100,000 salary and the IRA contribution limit is $9,000, determine how much they should save in each type of account.

10. Julie is married and wants to save $24,000 this year with their spouse. If their 401(k) offers a match of 100% up to 5.3% of their $106,000 salary and the IRA contribution limit is $9,000, determine how much they should save in each type of account.

Solutions