With seemingly limitless investment options and account types, how can we prioritize them and allocate savings in the most optimal way? The tax benefits of different account types are a huge factor, whether it’s deferring taxes now or getting tax free withdrawals in the future. Liquidity can be another big consideration because you don’t want your emergency funds or money for a house down payment invested in a risky manner or locked into an account where you would face penalties for early withdrawals. There are many other considerations about the benefits and drawbacks of different accounts, so it’s important to think about your own personal situation as well. Many of these accounts are driven by employers through employee benefit packages, which means not everyone has access to the same opportunities. The way I’m breaking down this example is somewhat typical of a mid-salary corporate employee. This obviously doesn’t apply to everyone, but it’s a good starting point to think about and adapt to your own situation.
Employer 401k Match
Taking advantage of any matching funds your employer offers for 401k contributions is a no brainer, and there are very few reasons for not taking advantage of it. This is free money and if you don’t contribute up to this level it’s equivalent to taking a voluntary salary reduction. There are very few guarantees when it comes to investing your money, but this is one of them. If your employer offers 75% matching up to a certain amount, that’s like getting a 75% return on your investment instantly without the market even changing. If all you did at a young age was start investing at this level and continue it consistently throughout your working career, it would be a great start towards a future retirement. These funds are also tax-deferred, so you get further benefits through a current year tax deduction as well (some also have a Roth option). The only big caveat to think about here is that employer matching funds are usually subject to a vesting schedule, so you may lose some or all of the funds if you left the job before being vested. Even with that being the case it usually makes to contribute at least up to this level without knowing your future career plans.
I like to consider paying off debt as a savings category on its own. It seems a little strange, but the end result is the same: increasing your net worth. Whether you use current cash flow to invest in assets that grow over time, or pay off past debts to eliminate those expenses, both options boost your overall financial picture. I put this category here, but it could easily fall much further down the list depending on the type of debt, interest rates and many other factors. Personal feelings and opinions also play a huge part here, much more than other areas. With mortgage rates so low currently I wouldn’t push people to pay down a home loan sooner, but for some people it can feel really good to pay off the house and live debt free. The types of debt I would prioritize here would be consumer debt like credit cards or personal loans, and any high-interest rate student loans. Some credit cards have rates above 20%, so that’s an emergency that needs to be taken care of as soon as possible if you carry a balance on any cards. As I said about employer matching funds, there are few guarantees we can get related to investing, but this is another one. If you have a 7% student loan you decide to pay down early, that equates to an investment with a guaranteed, no-risk 7% rate of return. Pretty good if you have debt to tackle and will quickly improve your overall financial situation! In the current environment, I think any debt with interest rate over 5% is worth consideration for paying early (or refinancing) depending on your overall situation and goals.
Health Savings Account
HSAs sometimes slip through the cracks, but they are the most tax-advantaged account in existence and can be a huge piece of both current medical planning and retirement. They have to be paired with a high-deductible health insurance plan, which are pretty common these days, but if you have access to this sort of plan you should make every attempt to max out the HSA if you can (2020 limits - $3550 for Single, $7100 for Family, $1000 catch up for over age 55). An HSA can truly be considered a long-term savings or retirement account because they can build significantly over time with no yearly spending requirements (unlike an FSA). HSAs have a triple tax advantage: you get a current year tax deduction for any contributions, the account grows tax free, and finally withdrawals are tax free if used for qualifying medical expenses. This is some of the only money you’ll never have to pay tax on, and it comes with some other advantages as well. Most HSA accounts allow you to invest the money once you reach a certain threshold, so over time you can get most of the balance invested and keep it growing instead of sitting in a low-interest savings account. They can also serve as the emergency fund for anything medical related. Once the balance is built up a little it can provide peace of mind about any unexpected issues, and you won’t need to worry about your high deductible because the HSA is there to cover it. But what if I don’t ever need all this money for medical expenses? Congratulations, you’ve won the health lottery! You still win with an HSA in retirement though because after age 65 it can be used the same as a traditional IRA where you can take out funds for any expenses without penalty, you just have to pay income tax on withdrawals if they aren’t for medical expenses.
Leaving the realm of employer sponsored accounts, a Roth IRA is a great option to consider next, as long as you aren’t over the income limit to be eligible (https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2020). Current year limits are $6000 per person ($7000 if above 50), and although you don’t get a current year tax deduction, they won’t be taxed in retirement and offer some other unique advantages. If you have most of your money in a pre-tax employer plan or traditional IRA the downside is that you can have a huge tax burden in the future, so any money in Roth accounts can help balance that out and diversify your future tax situation. It’s hard to predict future tax rates, but they probably aren’t going any lower than right now and I prefer not to have all the tax eggs in one basket. Roth IRAs also offer more flexibility than pre-tax accounts because contributions can be taken out at any time without penalty, providing some security for emergencies. This is also a useful tool for early retirement planning because any traditional IRA funds that are converted to Roth are considered contributions that can be withdrawn penalty-free after a five-year waiting period.
Funding 401k to Maximum
This could potentially be considered sooner but depends a lot on the quality of the employer plan. Things to think about are plan fees, available investment options and any other benefits the plan might have. For 2020 the maximum contribution is $19,500 (additional $6,500 if over 50), so this will usually be the biggest investment bucket for most middle-income earners. Filling this up with either pre-tax or Roth contributions will provide great benefits over time in allowing your money to grow.
Taxable Investment Account
If you have maxed out and taken advantage of all tax-advantaged accounts you have access to, then it’s probably time to start thinking about a taxable investment account. These accounts are extremely flexible because money can be taken in and out at any time, and you can invest in just about anything. The downside compared to accounts we’ve talked about so far is the lack of tax advantages. Any dividends or interest you receive is taxed in the current year, and any time you’re selling investments you can be subject to capital gains tax.
Other Things to Think About
While this is general idea about how someone with a typical benefits package could approach their savings, there are many other options that could be considered. You also need to make sure you have an emergency fund in place before going too far down this road. If you have kids and saving for their future education is a priority, then a 529 account is a great option. You can get a current year tax deduction from the State of Iowa ($3,439 per beneficiary for 2020), and the future withdrawals are tax-free at the federal and state levels if used for education. If you’re a government employee you’ll most likely have a 403b instead of a 401k, but it’s possible you’ll also have access to a 457 plan as well. This allows for even more tax advantaged savings if you have both. Some larger employers offer an ESPP (employee stock purchase plan), which can be a consideration for buying employer stock at a discounted price. No matter what savings vehicle we’re talking about here, it’s important to be mindful of the fees and expenses associated with the account, and how everything fits with your overall goals. If you need help evaluating what savings options you have available to you and how to prioritize them, schedule a meeting to start talking through it.