A savings waterfall is a tool to help investors prioritize savings goals and allocate funds appropriately.

First, you must satisfy your essential living expenses. This can be imagined as the static pool at the top of the waterfall.

If your spending exceeds your means, then you may be struggling with a dry bed rather than a static pool. In this circumstance, you are not ready for a savings waterfall. You need to first take on the task of curbing your spending and budgeting.

When your spending is within your means, you will have more income than you need to spend. In the analogy, this can be thought of as the pool overflowing. If you have a savings waterfall in place, then the overflow can simply trickle down the rocks and into your well-placed buckets so that you intentionally use the overflow.

A savings waterfall helps investors prioritize their options and navigate the financial complexity available for them. With a savings waterfall, you immediately know which buckets should fill when there is excess and which should remain dry if there isn’t enough for all your goals.

Most investors have access to several different types of retirement accounts which could be a bucket in their savings waterfall. Which account is best depends on the specific circumstances. For this reason, most investors benefit from designing a custom savings waterfall, tailored to their specific goals and situation.

However, there are some general guidelines which can assist in your design.

Overall Guidelines

By default, choose Roth.

Most retirement accounts offer a choice between contributing pre-tax traditional or post-tax Roth. In our experience, most people benefit from Roth contributions. We have written several articles on this topic including “Fund Your Roth IRA Even When You Can’t Afford It” and “The Role of a Roth IRA in Early Retirement.”

Our guide assumes that you benefit from Roth funding. However, there is a chance that you may benefit from contributing to a traditional IRA instead of a Roth IRA. If you have one of those cases, then our generic advice doesn’t fit your situation as well.

Unless stated otherwise, our advice is to fully fill each bucket before moving on to the next one.

While there are some steps in this guide where we recommend only partially using an account at first and then later going back to fill it, by default we recommend that you maximize the account before moving on to the next one.

You can find the updated 2023 contribution limits here. They have all increased with inflation since 2022. This means employees can save more in each bucket than last year. Hopefully your own salary has also increased with inflation and you can easily use that extra to increase your savings. If it hasn’t, consider asking your employer for a raise or raising your prices.

1. Pay off any credit card debt.

Each month you fail to pay off your credit card balance, you subject all your past and future spending to exorbitant interest rates of 18% or higher. To a financial planner, credit card debt is like having a cluster of thousands of baby spiders crawling on your body and under your clothes: You cannot act fast enough and there is no amount of modesty worth leaving the situation unresolved.

While we hope that our readers are starting from a clean slate, it is still important to mention. Before you do any other kind of saving, get out of credit card debt.

We do not recommend that you start a savings waterfall until the static pool which meets your basic living expenses is full.

2. Pay the minimum for other types of debt at this stage.

Student loans, while annoying, can be managed to your advantage because of their low or subsidized interest rates and long 10-year duration. Although many are anxious to leave student loans behind, often the best way to accomplish this is to pay the minimum and start saving and investing toward your future financial security.

Mortgages are the best of all loans. Most Americans have a home mortgage. The rich often have two. The right answer is normally to pay your mortgage back as slowly as possible. A 30-year fixed mortgage with a low interest rate tied to a house that generally appreciates with inflation is typically a good strategy for building wealth. Even if your mortgage does not have a low interest rate, you should still consider paying the minimum. However, you should also watch interest rates for opportunities to refinance to a lower 30-year fixed rate.

Other loans and especially short-term loans are more questionable. In general, if you cannot afford to pay for something out of pocket, you should not get a loan to purchase it. For this reason, home improvement loans, personal loans, paycheck loans, or even short-term business loans should generally be avoided. However, if you already have one, you likely do not need to pay it off before continuing on to other savings, but you should check the interest rate.

3. Flow qualified education expenses through a 529 plan.

529 plans, or Qualified Tuition Programs as the federal government calls them, are specialized investment accounts which give tax-advantaged savings for education expenses. 529 plans are typically the best vehicle to save for college. Each state has their own 529 plan.

In Virginia, contributions to a Virginia 529 plan offer the account owner a Virginia state tax deduction. Then, distributions to reimburse for any qualified education expenses are distributed both state and federal tax-free. For those under age 70, the deduction limit is $4,000 per account per year. However, because of how easy it is to open another unique account, you are effectively only limited in your annual Virginia state deduction by your ability to tolerate paperwork and tedious complexity. For those over age 70, there is no deduction limit.

If you have qualified education expenses in your budget now, then you should consider opening a 529 plan. Examples of qualifying expenses are K-12 tuition up to $10,000 per beneficiary per year, student loans up to $10,000 per lifetime, higher education tuition from eligible educational institutions, and many related expenses.

If you are already spending money on one of these items, then you could potentially save money on your state taxes by contributing to and then immediately distributing from a 529 plan.

For example if you are currently in graduate school, going to seminary, repaying your student loans, paying for K-12 tuition, gaining professional credentialing from an accredited school, or other types of education, you should look into whether you can save money by opening a 529 plan. You may find you benefit from opening an account where you are the beneficiary as well as some where your children are beneficiaries.

For example, here in Virginia, by flowing $10,000 of K-12 tuition money through Virginia 529 accounts for the beneficiary, a Virginia tax payer could receive a $575 discount on their private school tuition due to the state tax refund. This can be as simple as putting the money in one day, leaving it invested in cash, and taking the money out the next day.

At this step, don’t worry about funding the account for more than your expenses. Instead, simply contribute what you would have spent to the 529 plan anyway and then pay for your expenses out of the 529 plan. In a later step after you’ve taken care of some important retirement savings, we will suggest circling back to the 529 plan for longer term savings.

4. Defer to Roth 401(k) or 403(b) for full employer match.

Many employers sponsor a retirement contribution plan such as a 401(k) or a 403(b). Some also offer a match program whereby the employer matches an employee’s contributions.

An example of this would be for the first 3% of the employee’s salary contributed, the employer matches the contribution and then the employer matches half of the next 2% as well. This matching methodology is often called a safe harbor match and is very common.

Contributing 5% of your salary and receiving a match of 4% of your salary is the quickest way of earning an 80% return. For this reason, if your employer offers a match you should prioritize contributing enough to get the full match offered.

Depending on your plan, you may be able to select between a Roth deferral or a traditional deferral. However, regardless of where you contribute, your employer match will always be put into a traditional account.

Roth deferrals do not receive a tax deduction but avoid all future taxes. Traditional deferrals receive a tax deduction but will face taxes when you withdraw the larger appreciated amount in retirement.

A Roth contribution is generally preferable, but if one is not available defer traditional in order to get you full employer match. The benefit of the free money far outweighs potential downsides of the traditional account type.

It is important to note that funding your 401(k) or 403(b) match is not sufficient to fund your retirement. Funding your retirement plan to get the match invests only 9% of your take home pay when you should invest at least 15% to be on track for your retirement. You will need to invest more if your retirement plan doesn’t have a match or you are starting late and need to catch up.

Chances are the IRS contribution limit is higher than 5% of your salary, but at this step in your funding plan, we recommend only contributing enough to get your match. At a later step and if you still have savings left to contribute somewhere, we will recommend deferring more into your employer plan.

5. Budget at least 10% for unknowns.

None of us can anticipate all of our expenses. Every stage of life brings a whole new set of unanticipated needs. Even after identifying every outflow you think you might have, there will still be significant unexpected costs.

For this reason, we recommend constantly budgeting for surprises by setting aside at least 10% of your budget each month into an “Unknown Budget.” We call this budget the Unknown Budget because the question everyone asks is, “Like what?” and that is the point. You do not know how you will spend this budget.

We all have irregular and unexpected events that adversely impact our finances. Your work hours are cut back. You are widowed. The car breaks. You need to go to the emergency room. The roof leaks. You need to fly to a family funeral. Your daughter gets married. Lightning strikes a hole in your roof. Or more!

In economics, these are called financial shocks. It is because of financial shocks that many people have to borrow from credit cards.

When you are always contributing to and replenishing your unknown budget, you are protecting yourself from the financial shocks that life will inevitably bring. Although for many years this budget might accumulate in long-term savings, you will also unfortunately use this budget more often than you’d think.

This budget can be saved inside other retirement accounts, so long as you can withdraw from that account in an emergency. When you see a ** in one of the other funding options below, you will find our note on using that account type as your unknown budget.

6. Fund your Health Savings Account (HSA).

Not everyone has access to a Health Savings Account, but if you do, you should prioritize contributing to it. A Health Savings Account (HSA) is a rare type of account where you can get a tax deduction when you put the money in and then pay no tax when you take the money out for qualified medical expenses. High income earners who are not allowed to contribute to their Roth IRA or deduct contributions to traditional IRAs are still allowed to deduct contributions to HSAs.

We recommend that you fund your Health Savings Account (HSA) to the maximum limit each year and that you keep funding it to the maximum as long as you can no matter how much money you have in the account.

Funding your HSA to the maximum has many advantages and few disadvantages. The primary reason to have HSA-compatible health insurance is specifically to be able to fund your HSA. If you do not have sufficient savings to get to this point, you might benefit from cheaper Bronze health insurance which is not HSA-compatible.

Most HSA investors are able to use their entire HSA balance during their lifetime. For example, HSAs can help provide a tax efficient way to self-insure for long-term care. HSAs can also function like an IRA with no required minimum distributions after age 65.

The contribution limit for HSAs is based on the type of health insurance plan that you have. In 2023, those limits are: If you have a single plan (only one insured person), then you can contribute $3,850. If you have a family plan (two or more insured people), then you can contribute $7,750.

On top of those amounts if you are age 55 or over, you are entitled to a $1,000 catch-up contribution. (Note that the HSA catch-up starts later at age 55, rather than age 50 like most other accounts.)

Even if they are on the same insurance, both spouses can make the HSA catch-up contribution and adult children are entitled to their own contribution limit.

** Several potential emergencies are health related. As a result, saving some of your emergency budget in your HSA is a wise strategy. What is more, you may be surprised to find that some of your regular spending is actually qualified medical expenses. If that is the case, it is smart tax planning to contribute to the HSA even if you are going to spend the money that year on medical expenses.

7. Contribute to Roth IRA or use a Backdoor Roth IRA strategy.

Roth IRAs are amazing tax saving tools. Even though there is no deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2. The long-term benefits can be significant.

Your ability to contribute to a Roth IRA or receive a deduction for traditional IRA contributions is restricted as your income goes beyond a certain threshold. However regardless of your income level, you are still allowed to make a nondeductible contribution to your traditional IRA. If you file correctly, this contribution is put into your pre-tax account after taxes. That after-tax portion becomes a so-called nondeductible basis and is tracked as a part of the IRA until the account is emptied. Making nondeductible contributions to your traditional IRA and then converting them to Roth IRA is called a backdoor Roth because when implemented properly it can be tax identical to funding your Roth IRA directly.

We suggest you fund your Roth IRA even when you can’t afford it and that you use taxable savings as your seed money to live off of if you have to. If you have already used up all of your savings prior to this point, you should still open a Roth IRA and contribute $1 to it in order to begin the calendar for the 5-year Roth rule.

Contributing to a Roth IRA requires earned income (officially called “taxable compensation”). The most common sources of earned income are wages, self-employment income, some older alimony agreements, or household wages.

The IRS limit for contributions is how much earned income you had or the contribution limit whichever is smaller. In a marriage, spouses can pool their earned income and contribute to either person’s Roth IRA up to that pooled total or the contribution limit, whichever is smaller. This means stay-at-home parents can still fund their Roth IRAs using their working spouse’s earned income qualification.

For 2023, the IRA contribution limit is $6,500 for those age 49 or under and $7,500 for those age 50 or older. These limits are shared by Roth IRAs, traditional IRAs, and backdoor Roths (nondeductible contributions to traditional IRAs) and you can make prior year contributions until the filing deadline for your tax return.

** Roth IRAs make great emergency funds. At all times and at any age, you can withdraw as much as you have contributed to a Roth IRA without tax or penalty. For some families, 10% of their take home pay is less than or equal to the contribution limit. In this way, some families can mentally earmark one spouse’s Roth IRA as the emergency budget and earmark the other as the retirement fund. This mental thinking can help them in their savings targets. What is more, if you haven’t fully funded your Roth IRA yet for the relevant tax year and find that you have some leftover cash in your checking account, you can use it to fund your Roth IRA a bit more. So long as you are under the contribution limits, there is little downside as you can always withdraw it again.

8. Finish funding your Roth 401(k) or 403(b).

Now that your Roth IRA and HSA are fully funded, it is time to circle back to your employer sponsored retirement plan. If you have savings left, the time has come to maximize your 401(k) or 403(b) contributions.

You can increase the deferrals up to the contribution maximums. For 2023, the maximum employee deferral is $22,500 for those age 49 and under and $30,000 for those age 50 or older.

Some employees receive extra pay at the end of year as a bonus from their employer. While you may need your salary throughout the year in order to satisfy your basic living expenses and earlier savings goals, some employees are able to elect to have more funds from this larger bonus paycheck deferred into the retirement plan. For example, if you’ve been deferring 5% to get the match throughout the year, you could elect a dollar amount for your final paycheck in order to top off the account.

This strategy can be done by coordinating with your payroll department and employer.

9. Defer to a Roth 457 plan.

The 457 plan is an uncommon type of employer sponsored retirement plan. It’s full name is a 457 Deferred Compensation Plan, but it is called a “457 plan” for short.

A 457 plan is a type of retirement plan that is available to governmental employers and some non-profit employers in the United States.

Unlike a 403(b) and 401(k), which share the same contribution limit, a 457 plan has its own contribution limit. This means that even if you have already fully funded your 403(b) to the maximum, you can still contribute to your 457 plan.

Many 457 plans offer a Roth option, which we recommend you select.

For 2023, the maximum employee deferral to a 457 plan is $22,500 for those age 49 and under and $30,000 for those age 50 or older.

10. Contribute to a SEP IRA.

A SEP IRA (Simplified Employee Pension IRA) is a type of retirement plan which is similar to a 401(k) plan except that it is only available to self-employed workers or contractors.

Unlike other plans, they do not have a post-tax Roth option, all contributions must be pre-tax traditional. However, also unlike other plans, the assets are immediately accessible by the account owner; they do not have to wait until they are “out of service” (retired or terminated) in order to access them. This means the balance of a SEP IRA could be converted to a Roth IRA in the same year your employer contributed to it.

If you have access to both a SEP IRA and a 401(k) or 403(b) plan through different employers, it is important to note that you can contribute to both a SEP and a 401(k). For example, some university professors also have self-employed business income from the speaking or consulting work they do on the side. In this case, they can contribute to their SEP IRA from their self-employed business income while also deferring some of their university pay into their employer plan.

The SEP IRA contribution limit for 2023 is the lesser of 25% of your compensation or $66,000. Because of self-employment tax, the calculations for precisely how much can be contributed can be tricky, but your tax preparer can easily tell you how much you can contribute each year. Also, just like other IRAs, contributions can be made for the prior year until you file your taxes.

We would also recommend that you consider converting your SEP IRA to Roth IRA each year. This can effectively be a backdoor Roth strategy as you will receive a deduction for the SEP IRA contribution while also reporting the Roth conversion amount as taxable income. These two numbers (taxable distribution and deduction) should offset one another, effectively meaning that you have no or little additional tax due.

** Because you can convert your SEP IRA assets to Roth IRA at any time and because Roth conversion are available for withdrawal as contribution basis 5 years after the conversion, SEP IRA funding can be considered another place to save your emergency fund. Just keep in mind, these assets will only be accessible without penalty when you are of retirement age or 5 years after you convert to Roth IRA.

11. Consider deferring to other employer sponsored plans.

There are many different types of employer-sponsored plans. Some of them are great financial planning vehicles. If you ask your current employer what options you have, you may find that you have options you didn’t even know about.

Consider a SIMPLE IRA, thrift-saving plan, or deferred compensation options at this stage.

12. Save for future education expenses in a 529 plan.

As mentioned before, 529 plans are specialized investment accounts which give tax-advantaged savings for education expenses. 529 plans are typically the best vehicle to save for college.

This step of savings is a good time to contribute to a 529 plan for long-term savings goals. If you want to pay for your children’s education without the need for student loans or scholarships, then the best plan is to start saving for this goal the day that they are born.

Even though college savings has a shorter time frame than your retirement, we recommend prioritizing your retirement. You can help your children pay back their student loans at favorable interest rates a lot easier than you can replace your lost retirement savings late in the journey.

Even though a college savings account is one of the last accounts you should fund, 529 plans can be very versatile. They can be used for many types of education expenses, as discussed earlier, and they can even be transferred from one family member to another. A 529 plan can help you with your estate planning as well.

Most of the money in the 529 plans we help manage is owned by grandparents for a wide variety of reasons, but if you have extra savings left at this point and anticipate future education expenses, you would likely benefit from saving in a 529 plan.

13. Consider a systematic Roth conversion plan.

If you’ve made it this far in your savings steps, you would likely benefit from considering a systematic Roth conversion strategy.

Generally speaking, if you have any money in a taxable brokerage account you might benefit from engaging in a systematic Roth conversion plan. Roth conversion plans can get complex, but there are some simple rules that can guide you. Generally, doing something is better than nothing. Since Roth conversions cannot be undone, make sure that you understand how much money you will owe before you complete a Roth conversion.

For more on this concept, you may enjoy reading “The 30-Year Value of a Single Roth Conversion” or watching “Video: The Value of Systematic Roth Conversions.”

14. Save in a regular, taxable brokerage account.

If you have any money left over, then the default place to save is a regular, taxable brokerage account. The dividends, interest, and realized capital gains are all taxed each year in a taxable account. This consistent taxation is like a headwind on your compound growth and will create a drag on your investments.

If you already have large sums saved in a taxable account, then consider using those taxable funds to support your lifestyle spending so you can increase your deferrals and/or contributions elsewhere. You can do this increased retirement account funding until your taxable account is depleted. This is what we mean when we say that you should fund your Roth IRA even when you can’t afford it. You can use the assets currently in your taxable account to support your contributions to the accounts listed before this one.

** A taxable account is obviously a fine location to save your unknown budget.

15. Pay down debt.

While paying down credit card debt is the first priority, you can see that other types of debt are at the end of the list. We have included this in the list because people will ask where it is in our ordering, but you may never get to this one.

Paying down debt which is at low interest rates (like student debt or your mortgage) is not as advantageous as saving in a brokerage account. As interest rates rise, paying down debt becomes more important. Only if the interest rate is perhaps 6% or more should you consider paying more than the minimum.

You can see some of the math of how this works in “Q&A: Should I Get a Car Loan To Stay Invested?”

16. Consider family gifting.

Generational financial planning techniques can reduce the burden of taxes on the family as a whole.

By transferring assets to the next generation during your lifetime, you are gifting not only the original value but the future growth of those assets. Lifetime gifts can assist in reducing the size of your estate, empowering your children or grandchildren in their own financial goals, or enhancing the after-tax net worth for the family as a whole.

Like charitable giving, family giving should only be used if it matches your financial goals. For many though, family giving is a source of great joy and value.

For 2023, one donor can give up to $17,000 per donee. With gift splitting, a couple can give $17,000 each or $34,000 per donee.

Conclusion

These are our generic savings priorities. If you have access to a type of account which we did not include in this list, send us a message on our Contact Form and we will consider including it in next year’s priorities.

If you’d like more support or customized advice, then you may appreciate our ongoing investment management and financial planning services.

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