Disclaimer: Nothing in this article should ever be considered advice, research or an invitation to buy or sell securities. I am not a financial advisor.
The goal of investing is to maximize returns and minimize friction (i.e., taxes, fees, interest paid, etc.).
But how is this done?
- Do we fund our Individual Retirement Account before or after our Health Savings Account?
- Do we prioritize extra payments on a mortgage before maxing out our 401(k)?
- Do we pay off all our debt before contributing to a tax-advantaged investment account?
With so many different types of investment accounts and forms of debt, it can be overwhelming to understand where we should put our hard-earned money in order to optimize our investing strategy.
As a result, today we will be looking at a general funding priority guide for how we can stretch our dollars as far as possible.
Let’s dive in.
High Yield Savings Account (Emergency Fund)
No matter what our financial situation is, the first type of account that we should fund is our emergency fund. That is because an emergency fund provides a critical safety net for when we are in less-than-ideal financial situations.
A common baseline to strive for is having enough easily accessible cash in order to cover 3-6 months of living expenses. When building our emergency fund, we need to differentiate between our needs and wants and prioritize covering our basic living expenses (i.e., food, shelter, etc.).
With that being said, the size of an individual’s emergency fund ultimately depends on a mixture of factors including:
- Individual risk tolerances
- Personal income situation
- Potential expenses on the horizon
One of the best places to store an emergency fund is a FDIC insured high yield savings account. These savings accounts are identical to savings accounts that can be found at brick-and-mortar banks/credit unions but often offer much more competitive rates. As an example, Ally is currently offering 2.35% APY on their online savings accounts. Whereas the national average, as reported by the FDIC, is 0.21% as of October 17, 2022.
High yield savings accounts are excellent because they offer the liquidity of a saving account as well as higher-than-average APY yields to hedge against inflation. While other short-term investments like CDs or short-term bonds can offer better yields, they don’t provide the same level of accessibility that is desired in an emergency situation.
Company 401(k) (Up to the Match, Not Maxed)
If we work for a company that offers a 401(k) with a matching contribution program, then our next priority should be funding our 401(k) up to whatever the employer’s match limit is. This is where we begin building wealth.
Depending on the company’s offering, we may have the option to choose between traditional or Roth contributions. The advantage of traditional (pre-tax) contributions is that it lowers our taxable income for that year. Whereas the advantage of Roth (post-tax) contributions is that our 401(k)’s earnings can grow tax-free.
Whether we are making traditional or Roth contributions, we should still contribute up the matching contribution limit. In a nutshell, a matching contribution is when an employer will contribute to our 401(k) account up to a certain amount. This matching contribution is free money and represents an instant 100% return on our contributions.
As an example, an individual who contributes 5% of their $50,000 salary to their 401(k) will end up saving $2500 annually. However, if their company had a 100% matching contribution program on the first 5% of contributions that an employee makes, then the total contributions to their 401(k) would total to $5000 or a 100% rate of return.
According to Vanguard, the average 401(k) employer contribution rate in 2020 was 4.5%.
Not taking advantage of an employer match is the equivalent to leaving a part of our salary on the table. Even if an employer’s 401(k) investment offerings are less-than-ideal with higher fees, it’s still free money that can later be transferred to another type of investment account with better investment options.
High Interest Loans
Up until this point, we have looked at building up the asset side our personal balance sheet. However, our financial priority should now shift to paying down our liabilities in the form of high interest loans that include personal loans, unsecured loans, credit cards, etc.
These high interest loans can take a large % of our earnings every month which doesn’t allow us to maximize our overall savings rate. Therefore, chipping away at our high interest debt can actively increase the amount of cash we have on hand that can then be invested.
When paying off high interest debt, there is a direct return on investment. If a credit card is charging 20% interest every month, then paying off that debt would result in an instant 20% return on our money.
Furthermore, according to the time value of money, it can more prudent to pay off this high interest debt rather than invest in stocks or bonds. That is because the probability of finding an investment that can earn +20% month-over-month is low and likely not worth the effort or stress.
Health Savings Account (If Applicable)
If we are enrolled in a High Deductible Health Plan (HDHP), we have access to one of those the best tax-advantaged investment accounts available: the Health Savings Account (HSA).
An HSA is an investment account that can be used to cover qualified medical expenses. Unlike the Flexible Saving Account (FSA), any funds accumulated in an HSA do not need to be spent in the calendar year that they were saved; the balance is simply rolled into the next year. Furthermore, HSAs have the ability to invest in different assets like index or target-date funds.
HSAs are unique in the sense that they are triplex-tax-advantaged, meaning that:
- Initial contributions are not taxed
- Investment growth is not taxed
- Qualified withdrawals for healthcare spending are not taxed
HSAs are also attractive because they can also be used as an Individual Retirement Account (IRA). Starting at the age of 65, one can withdraw HSA funds for non-medical expenses. However, those disbursements would then be taxed at your regular tax rate.
In the event that we switch companies or stop using a HDHP, we will lose the ability to contribute additional funds to our HSA. However, we still would retain ownership of the funds within the account.
Individual Retirement Account and/or Company 401(k)
At this point, there are several different tax-advantaged accounts that we can prioritize to fund.
Option 1 – We finish funding our company 401(k) if our company’s investment options:
- Match our individual risk tolerance
- Have low fees
While most 401(k)s offer a mix of investment options that we can leverage to match the amount of risk we want in our portfolio, they may have less-than-ideal fees.
Fees are critically important because they can eat into our portfolio’s overall performance. As a result, it’s important to do our homework and evaluate whether or not there are identical funds that can we can invest in elsewhere with a lower fee structure.
If our 401(k) investment options do come with egregious fees, it may be worthwhile to consider Option 2.
Option 2 – We begin to contribute to either a Traditional or Roth IRA.
Unlike the 401(k), IRAs are not tied to employment.
As a result, there tends to be a lot more investment options available. Which type of IRA we decide to fund ultimately depends on when we want to see the tax benefit.
- If we want to lower our taxable income today and defer our taxes, we can contribute to a Traditional IRA
- If we want to be done with taxes and have our money grow tax free, we can contribute to a Roth IRA
Which IRA we decide to fund ultimately depends on our specific financial situation.
Medium Interest Loans
After funding our major retirement accounts, the funding priority shifts back to paying down debt.
In this case, our priority should center around medium interest loans such as HELOCS, Personal Loans, Car Loans, Student Loans, etc. Similar to high interest loans, if a medium interest loan is charging 6% interest every month, then paying off that debt would result in an instant 6% return on our money.
Paying down our medium-term loans also results in the following:
- Decreasing our debt
- Increasing our liquid net worth
- Freeing up more cash order in order to invest down the line
At the end of the day, which loans we decide to pay off first largely depends on whether or not we can expect to get a higher rate of return elsewhere. As an example, imagine we have the option to pay down a medium interest loan that costs us 6% interest or invest in I Bonds yielding 9.62%. According to the time value of money, it makes more financial sense to invest in the I Bonds.
Taxable Brokerage Account
At this point, we have funded most the major tax-advantaged accounts that are available for most people as well as paid off our most expensive debts.
As a result, if want to continue investing, then the next account we should fund is a Taxable Brokerage Account. From an investing perspective, this is where our money will experience some friction. That is because there are no immediate tax advantages upon contributing to these accounts.
With that being said, the biggest benefit with taxable brokerage accounts is the long-term capital gains tax. In a nutshell, if we sell an asset that we’ve held for more than a year, we can potentially pay 0% on the profits from that transaction. NerdWallet has a nice chart explaining the short vs long-term capital gains tax that you can find here.
When funding a taxable brokerage account, it’s important to understand what our current asset allocation is among our other accounts. This can help ensure that we are maintaining an asset allocation that matches our specific portfolio risk tolerance.
Low Interest Debt
The last account to fund is paying off our low interest debt.
The type of debt that has historically fit in this category are mortgages.
It’s the lowest priority to pay off because from a mathematical perspective, it makes more sense to invest in asset classes such as stocks/bonds that historically have higher rates of returns.
As an example, the mortgage rate on my personal residence is 3.625%. At such a low rate, I can invest in other asset classes that can potentially give me a much higher return. Going back to our I Bond example from earlier, I can invest in I Bonds @ 9.62% and have my money earn ~6% more than the 3.625% return I can get by paying down my mortgage.
With that being said, those currently on the path to home ownership are currently facing increasing mortgage rates. As a result, a new homeowner’s mortgage might be classified as "medium-term debt" and may deserve higher prioritization from a funding perspective.
Finally, there is something to be said about making extra payments on a mortgage to cut down the overall term of the mortgage. While an extra payment or two a year may be a good idea, if the interest rate is low enough, it still makes more mathematical sense to invest in assets that can produce higher returns.
Final Thoughts
When it comes to individual investing strategies, there is a chance we are not investing as efficiently as possible. That is because not all investment accounts are created equally.
However, everyone has different circumstances, goals and risk tolerances. What may make sense to one person may not necessarily work for another. If you have any questions about what accounts you should prioritize funding for your specific circumstance, consult with a Certified Financial Planner.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Investing Retirement Markets