Hierarchy of Savings

Every single person should have a clear hierarchy of savings, primarily driven by tax arbitrage (link). On January 1, where do you put your first dollar of savings in the year? What about your second dollar? 10,000th dollar? Etc?

I believe the following list should work for everyone, whether you’re making $10k or $10M per year, or whether you’re worth negative $100k or positive $100M.

  1. Contribute to 401k up to company match.
    1. It’s idiotic to turn down free money.
    2. Think hard about Roth vs Trad 401k decision (if Roth choice is available to you), as a mistake here can cost you hundreds of thousands later in life, though this post will probably lean you towards Trad.
  2. Get out of any debt > 5%, beginning with highest interest first.
    1. If you’re itemizing, your effective interest rate on mortgage debt is (1-EMTR%)*Mortgage Rate.
  3. Max out HSA (& limited purpose FSAs up to what you’ll spend) if offered by your employer.
    1. Pre-tax in and pre-tax out. HSAs are exempt from payroll taxes (6.2% soc sec + 1.45% medicare), which is not the case with retirement accounts, as well as state + federal.
    2. Best money you’ll ever spend.
    3. If you can afford the cash flow, don’t reimburse yourself immediately (link).
  4. Max out 403b & 457.
    1. If you work for a public institution like a university.
    2. If you have several kids and moderate income, prioritizing 403b&457 funding above IRA can help you to hack the EITC.
      1. If your 403b & 457 custodian is awful (high fees) and you aren’t trying to hack the EITC, then consider prioritizing IRAs above 403b & 457.
    3. 457 can be withdrawn at any age after severing from company without 10% early withdrawal penalty. 403b can not. However, 403b can be accessed before age 59.5 through Roth Conversion + 5 year seasoning period.
  5. Max out remainder of 401k.
    1. If you have several kids and moderate income, prioritizing 401k funding above IRA can help you to hack the EITC .
      1. If your 401k custodian is awful (high fees) and you aren’t trying to hack the EITC, then consider prioritizing IRAs above 403b & 457.
      2. 401k can be accessed before age 59.5 through Roth Conversion + 5 year seasoning period.
  6. Max out IRAs.
    1. X 2 if married.
    2. Think hard about Roth vs Trad IRA decision, as a mistake here can cost you hundreds of thousands later in life,  though this post will probably lean you towards Trad.
    3. Backdoor Roth IRA if your income is too high. Straight Roth if your income is above Trad IRA deductibility limit but below Roth IRA limit.
    4. If you want the ability to withdraw principal from a Roth IRA early for emergency funds or use a Roth IRA for a first time home purchase, consider prioritizing IRA above 403b & 457 & 401k.
    5. If you qualify for the Saver’s Credit, consider prioritizing IRA higher to ensure full receipt of the credit.
  7. Think hard about making after-tax contributions to a 401k.
    1. After capping out your $18k contributions to a 401k, think hard about making after-tax contributions to a 401k, especially if your company allows for in-service distributions. At first glance this might seem counter-intuitive. The point of the 401k is to get a tax benefit now because it will be taxed on the back end later. However, after-tax contributions can set you up for a lucrative Mega-Backdoor Roth (http://www.madfientist.com/after-tax-contributions/, https://www.whitecoatinvestor.com/the-mega-backdoor-roth-ira/).
    2. One of my big financial regrets is not exploiting this while working for 4 years at MegaCorp, which allowed for after-tax contributions to a 401k and in-service distributions. But this was years before I became aware of the strategy.
  8. Contribute to 529 up to state deduction limit if you have kids and care to assist with college.
  9. Taxable brokerage OR 529 over state deduction limit OR prepay mortgage.
    1. I can’t really think of a good reason to prioritize any of these three above the others.
      1. However, reader Dave below indicates that prepaying the mortgage is a great way of hacking the FAFSA to appear poorer for financial aid while paying for college, since the FAFSA (myopically) neglects home equity.

We’ve roughly adhered to the above list of priorities roughly our entire life, though only recently have we had the cash flow to get past number 5 above. I can’t think of a good reason why anyone would deviate from the above.

26 thoughts on “Hierarchy of Savings

  1. This is a great list! I’d add that even if your effective mortgage rate is below 5%, from a college aid perspective, you might be better off increasing your home equity than your taxable investments. (That is, unless your AGI is high enough that you have zero shot at any need-based financial aid for your children.) For schools that use the FAFSA form, home equity isn’t counted at all, though it can be a consideration for colleges that use the CSS form.

    • Thanks David! That’s a really good point.

      It’s amazing how many tax hacks are available once you live frugally enough to generate savings and put a few minutes of thought on how to allocate your savings across accounts. FAFSA hacking is definitely something I will become better versed in as my kids approach college age (oldest is currently 10 so still a few years off for me).

  2. It’s not that far off — our older kid just started 7th grade, but we’ll be using our 2021 tax return to apply for aid for her freshman year (2023-2024)! I’ve only started looking into aid strategies, but with no real foresight on my part, we’re fairly well positioned for FAFSA aid from an asset perspective, as most of our assets are in tax-deferred retirement accounts and home equity, both of which are shielded. Income, of course, is the other factor, and I was somewhat shocked to see that the effective family contribution includes a fairly high percentage of your AGI. And the “marginal rate” is even higher — for each additional dollar in AGI, we’d be expected to contribute 31 cents of it toward college costs. Combined with federal and state tax rates, that will push our total marginal rate into 70% territory for the years our children will be in college. It’s actually inspiring me to attempt to retire (or at least semi-retire) by the end of 2020.

    • I had forgotten about the lookback period for the FAFSA forms and the fact that you have to plan years in advance if you care to strategize around the FAFSA.

      One things for sure, the entire system (tax, financial aid, healthcare, etc) rewards low income. And that’s precisely the income scenario of an early retiree.

      You’ve certainly given me some food for thought on prioritizing the repayment of my mortgage sooner than later. I still remain convinced that a little bit of money in a taxable account is okay to aid in tax loss harvesting, but I guess I’m unsure how big I’ll let this pot grow before I start aggressively paying down the mortgage.

  3. I’ll tread carefully here, as I don’t want to come across as the relatively well-off guy whining about college costs. Overall, I have no problem with colleges giving more aid to lower-income families. However, what bugs me somewhat is that for any two families of equal income, the system rewards the one that hasn’t saved for college (or accumulated other assets) in the form of higher need-based aid!

    There’s another quirk that might work in your favor, as you have more kids than me – overlapping years in college. If the FAFSA form determines your effective family contribution is $25k a year, that’s the total, no matter how many kids you have in school in any given year. (With two kids in college, the FAFSA simply divides the total EFC in half for each kid.) That’s understandable, as if you can afford $25k a year from your income stream, you can’t necessarily afford 2X that amount if a second child enters college.

    But it does mean that the total cost of college for families with similar finances and the same number of children will vary greatly, based on the age distribution of those children. For example, a family with twins and an EFC of $25k will end up paying $100k for two college degrees. Yet a family with the same income and assets, but with kids who are four years apart, will spend twice as much for two degrees, paying the $25k EFC for eight years. Our two kids are three years apart, so we’ll only benefit from a single year of college overlap.

  4. Good list! Just a note about trad vs. Roth IRA: if you already have access to the 401k and your income is high enough, you might as well contribute to a Roth IRA instead of traditional because of the loss deduction benefits. For single filers, the deduction phase out starts at a MAGI of $62k and is completely lost at $72k. The 401k phase out is much higher, so most people are fine sticking with traditional 401k’s. (correct me if I’m wrong!)

    • Dylan, you are correct that Roth IRA clearly trumps Trad IRA for those who have high incomes who are either entering or exceeding the deductibility phase out range.

  5. regarding no. 6 maxing out 403b or 457. what if you don’t get any additional funds from your employee on it and they limit who you can invest through? My concern is the fees with the chosen investor are higher then paying the taxes and investing in an IRA on my own.

    • My current employer allows me to save $18k in a 403b and $18k in a 457 per year. The tax savings along on those two accounts is roughly $16.2k/year. If I were over 50, I’d be able to contribute $48k total rather than $36k total.

      In terms of tax arbitrage, this is a no brainer, even in the presence of high cost funds. When you leave your current employer, you can port the investments to Vanguard and pay essentially nothing in fees after the transfer. However, if you pass up on the opportunity to fund either account either year, the opportunity for tax arbitrage is lost forever. See https://www.frugalprofessor.com/how-to-mint-money-using-tax-arbitrage/

  6. 403b and 457’s should be higher on your listed, no lower than 4. Why, no penalty on withdrawals before 59. Reach your number and retire at any age.

    • Your points are very well taken about 457, as distributions can be withdrawn penalty free before 59.5.

      However, you are incorrect about 403b before 59.5, with the exception of severing from a company at 55. https://www.bogleheads.org/wiki/403(b)#Distributions

      Basic rules regarding distributions from a 403(b) plan include:

      A withdrawal of assets prior to age 59-1/2, will be taxable at income tax rates and will result in the IRS imposing a 10 percent penalty tax (unless certain criteria are met.)[note 3]
      Withdrawals are taxable unless one meets one of the following exclusions:
      Attain age 59-1/2
      Separate from service in or after the year in which you reach age 55

      With that said, 403b and 401k can be accessed early due to Roth Conversion Ladder strategy.

      • Jim, I reshuffled the list a bit and clarified a few things. Thanks for your input. With my marginal tax rate of 45%, I certainly prefer 403b&457 to IRAs because I’m above the TIRA deductibility phaseout.

  7. Good post to help with savings hierarchy. But one thing missing here – which I struggle with – is the relative priority of a fat emergency fund versus tax advantaged savings. I personally err on the side of having too much in retirement but very little cash. And I hope I won’t regret this l. But every time I build up a nice emergency fund I seem to have to do my taxes and the benefits make me raid the emergency fund to max out tax advantaged savings and then I need to spend another 6 months rebuilding the emergency fund. So this is something I personally struggle with getting the balance right on.

    • Dave, thanks for the post. An emergency fund is something I haven’t quite figured out either. I currently have 50k in Roths which I can liquidate in a moments notice in the event of a true emergency that couldn’t be handled with cash on hand + credit cards. But frankly I’d probably prefer liquidating taxable brokerage stocks and pay a small tax penalty to access emergency funds. This would prevent the hemorrhaging of precious Roth accounts, which action cannot be undone.

  8. Thank you for this hierarchy! So helpful! I had no idea about number 7. I believe we are able to this and now I’ll have to check into that today. Also, appreciate the link to MF’s post on that topic!

    • Happy to help. If you could shove an extra $30k/year after tax into a 401k, then convert to a Roth for $0 in extra taxes, your Roth will be massive in a few short years, setting you up perfectly for early retirement.

      • Well, I found out that my husband’s employer allows for the mega backdoor Roth, at least from what I read in his 401k info booklet. So that’s great! But, we are limited to only contributing 40% (or less) of each paycheck towards his 401k, which means we would need to make $120k in order to fully fund the $18k and ~$30k into after-tax… which we don’t, unfortunately! But, at least we will be able to contribute some after-tax $$, just nothing near the full $30k.

        At the end of the sentence on 5.1.1., did you mean to put 401k instead of 403b and 457?

  9. This article really got me thinking. So essentially if you are close to a tax bracket cutoff can you use something like the 403 (b) to bump yourself down there by making contributions?

  10. My state has no income tax, hence no deductibility for a 529 plan for me.
    It seems like Number 9 could add:
    Fund UTMA account for your kids (if you want to help them).
    -Kids with less than 1k of investment income (dividends) don’t have to file a tax return.
    -But, of course this might hurt your kids come FASFA time.
    —–This begs the question, which is best: UTMA or 529? (perhaps Roth is best if you can somehow pay them).
    -529 does not hurt FASFA possibilities, right?

    • Tim, great to hear from you! How’s life?

      Seeing how you live in a state with no income tax, I can definitely understand the logic of not funding 529 plans.

      The first question is whether our kids will qualify for any need-based financial aid in the first place. If not, the whole discussion about the FAFSA is moot. I think it will likely be moot for both of us, but let’s pretend that it’s not.

      This looked informative:
      https://www.forbes.com/sites/troyonink/2014/02/14/how-assets-hurt-college-aid-eligibility-on-fafsa-and-css-profile/#21c072c323ec
      If your child has $25,000 in savings account, the child will be expected to contribute 20% of the asset ($5,000) each year toward the cost of college under the federal methodology, 25% under the IM ($6,250) and only 5% under the CM ($1,250). If your child owns a 529 college account of Coverdell ESA the aid treatment is more favorable under the federal calculation. The same $25,000 in a 529 account will only be assessed at a maximum of 5.64%, and sometimes it may not be assessed at all.

      So the name of the game for FAFSA hacking is to get as little assets in the name of the child (UGMA/UTMA) with an expected contribution rate of 20% and as much assets into the 529 plan with an expected contribution rate of 5.64%.

      I’ve also read that Roth IRA assets don’t count towards expected contributions:
      http://www.kiplinger.com/article/college/T042-C001-S001-how-roth-iras-affect-financial-aid-eligibility.html
      Retirement account balances — such as in Roth and traditional IRAs, 401(k)s and 403(b)s — aren’t reported as assets on the Free Application for Federal Student Aid (FAFSA), regardless of whether they’re owned by the student or the parent, says Mark Kantrowitz of Finaid.org. And the CSS Profile, an aid form that many private colleges use, does not factor retirement assets into need analysis, either.

      If I were solely interested in optimizing for the FAFSA, I suppose I’d prioritize the prepayment of mortgage above the funding of taxable brokerage accounts. Further, I’d fund my kids Roth IRAs prior to their 529s. However, they aren’t working yet so I can’t do this yet. I fully intend to do so once they start working though.

      If we revert back to not caring about the FAFSA, I think UGMA/UTMA trumps 529. This post was informative: https://www.bogleheads.org/forum/viewtopic.php?t=135851#p2005687.

  11. Great information! What would you consider high fees? The fees on the index fund in my 401k is .37%, the one in my 457 is .54% and the 403b is .67%. I have no employer match because I have a pension. In this case should I max out the 457 Soni can pull it out without penalty? Also, should I max out the HSA over the 457 even if I’m not getting the full FICA benefit (I don’t contribute to SS taxes)? Thanks!

    • What is your effective marginal tax rate? Family size?
      https://www.frugalprofessor.com/etic-guest-post-on-gocurrycracker/
      https://www.frugalprofessor.com/updated-tax-calculator/

      If I were you, I’d go HSA first. It’s tax free in and tax free out. This is why it’s at the top of my list (after 401k up to company match). To contribute to a HSA you must have an eligible HDHP plan. It’s worth it even if you don’t pay payroll taxes. http://www.madfientist.com/ultimate-retirement-account/.

      The fees that you mention are high. As a result, I’d prioritize IRA contributions above 403b/457, unless you’re hacking the EITC (in which case 403b/457 trumps).

      Even with the somewhat high fees, I’d prioritize 403b/457 before taxable brokerage or prepaying mortgage. Once you leave your firm, you can roll both into a Trad IRA at Vanguard which charges 0.04% for a total US stock market fund.

      If you forgo these 403b/457 contributions, you lose the opportunity forever once Dec 31 passes.

      It’s hard to overstate the tax benefits from thinking strategically about your taxes. It will easily save me many hundreds of thousands of dollars over my life. There are few activities in life that have such a profound return on your time.

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