Prioritizing Investment Accounts
We already covered the basic accounts you can use to invest. But now we’re going to talk about the order in which you should fund them. As you start to cut back on expenses and your savings rate increases there’s going to be a gusher of extra money suddenly coming at you. Get ready for it by following a few simple steps to determine where you should direct the fire hose.
Establish an Emergency Fund
I will include this for completeness, but for various reasons Mrs. and Mr. Grizzly don’t actually keep anything specifically designated as an ’emergency fund’. You can read our full analysis of emergency funds and why we’re not huge fans here. Our main belief is that we should view our entire investment portfolio as one complete entity, and if we wouldn’t keep a large percent of our net worth in cash we shouldn’t keep a large designated emergency fund. However, people differ in how much risk they are willing to take on and in their current financial circumstances, so I will include this as the first step. Establish a basic cushion that you are comfortable with to make sure you are not overdrawing accounts and maxing out credit cards if you’re out of work for several months before proceeding.
Fund any 401ks up to employer match limits
This one is easy. Employer matches on 401ks are literally free money and likely the highest immediate return you will get anywhere. A 50% match is an instant 50% return on anything you invest. Even at lower match rates, this is almost always a no-brainer. If the match is high enough this should take precedence even over paying off high-interest rate debt. Take the free money. Take it!
Pay off high-interest rate debt
The ideal situation is that you don’t have any of this built up, and if you do you then you should find some way to refinance it to a lower rate. When I say high-interest rate debt, what do I mean? I define it as anything 4-5% above the current US 10 year treasury yield, the rate the US government is currently paying (economists like to call this the ‘risk-free’ rate). Today that would mean anything with a rate of about 6% or above. This is the rough equivalent of any debt with an interest rate higher than the average return on the stock market. Since paying down debt is a guaranteed return vs. the risk inherent in investments, this almost always trumps even tax-advantaged accounts over the long term.
Max out Health Savings Accounts if available
You can find a full post on HSAs here, but here are some teasers. If you’re covered under a health insurance plan that meets the criteria this is your next best option for additional cash. The HSA’s have a number of advantages over the other retirement accounts. The most important difference is that they allow pretax contributions but tax-free withdrawals for health care expenses. So you may never have to pay taxes if you use them for healthcare.
The key aspect of HSAs is to remember that you don’t have to pay healthcare expenses out of them! You can pay any healthcare costs out of current income or already taxed savings. But keep those receipts and records, because you can eventually use them to withdraw from your HSA tax-free without penalty.
Max out traditional or Roth IRAs
Next up are your personal IRA accounts outside of any 401k plan at an employer. These come next for one big reason. You have complete control over investment options. So if the funds available in your work 401k are pieces of high fee garbage then go immediately for an IRA. One the other hand, if you work for a great company that has a solid 401k plan, then this step can and should be swapped for the next one.
There is some degree of controversy over whether the Roth or the traditional IRA is ideal. The general rule of thumb is that if you are in the 25% or above tax bracket go for the traditional IRA. If you are in a lower tax bracket go for the Roth IRA. If you are in such a high tax bracket that you don’t qualify for either one (we’re in this situation), then you can still contribute after-tax dollars to an IRA.
Max out tax advantaged (Traditional/Roth) 401k plans at work
These follow the same basic rules of the IRAs above. Roth if <25%, traditional if >25%. Hope that your 401k doesn’t have only high fee crap. If you’re stuck with nothing but high fee funds, then spend your free time pressuring HR to get an SP500 index fund added to your options.
Max out your after-tax 401k or IRA contributions
This may or may not be available from your employer, but if it is then its the last of the tax-advantaged ways you can hide your money. Take advantage of it if it is offered, beat HR over the head if it’s not, and roll any contributions into a Roth IRA as soon as possible. The details of how this Roth conversion works can be found here at the IRS website. We will also cover in much greater depth in a later post. You can do something similar with after tax IRA contributions as well.
Fund taxable accounts or pay off low-interest rate debt
Last and final step. If you still have some money left over after all the rest, then you can decide between sticking it in a taxable account at Vanguard or paying off low-interest rate debt like your mortgage. I generally view these two as a tossup in terms of expected return, so it’s largely a matter of personal preference and your ability to handle risk.
Fund 529 Savings Plans to the extent you wish to pay for your children’s education
You’ll find a much deeper dive into how we’re planning on funding our daughter’s education here (we’re planning on paying 100% of undergrad). We’re using a very simple Vanguard 529 Plan. 529 Plans are tax-advantaged plans that can be used to fund education expenses. There are a number of restrictions on using them for other purposes, so we don’t recommend counting them as part of a retirement portfolio, but they should be included here for completeness.
Follow those few simple steps and you’ll find yourself with a pile of cash that’s growing more quickly every day. These are the basics. At the end, you’ll have money in 401ks, HSAs, and other various tax advantages accounts, and the remainder in taxable accounts. If you plan to retire early you will eventually need to access the money in these accounts. You can find out exactly how to do that in our post on accessing your retirement accounts without penalty.