We’re sure you have heard that individuals should save 15-20% of their income for a comfortable retirement. A common question that often results from this is where to invest those hard-earned dollars.
Although different individual situations can result in different paths, an overall goal of filling multiple buckets, with each having different tax treatments, is a smart path to financial freedom.
Following the order below will ensure a well tax-diversified portfolio in retirement.
1. Emergency Fund
Although this bucket isn’t intended to be invested like the others (the aim is safety of principal over return), an emergency fund is a critical foundation to any financial plan. This fund is where you store cash to pay for those unanticipated expenses. For example, what happens when you’re hit with a large medical bill, your car needs a new transmission, or the furnace gives out? Do you have cash in an account to pay for these items or are you forced to use a credit card or take out a loan?
The preferred rule-of-thumb is to maintain an emergency fund large enough to cover approximately three to six months of expenses. This account should be invested in a bank account or money market mutual fund.
2. Employer Provided Retirement Plans – up to match
If you’re fortunate enough to have a 401(k), 403(b) or SIMPLE plan that includes a match, you will want to contribute the percentage of your salary to take full advantage of any employer match. For example, if the plan is structured such that the employer will match 100% of your contributions up to 3% of pay, then you will want to contribute 3% of your paycheck to take advantage of the employer match. In this instance, the employer match gives you a 100% return on your investment!
3. Health Savings Accounts
If you are enrolled in a high-deductible medical insurance plan, then you can invest in a Health Savings Account (HSA). HSAs are accounts used to fund qualified medical expenses, and provide a triple tax benefit—the contribution is deductible, all earnings grow tax-deferred, and distributions for qualified medical expenses are tax-free. We recommend you use these plans to build assets for future medical expenses in retirement. These accounts only realize their full potential when the balances are invested with a significant weighting in equities.
4. Roth IRAs/Roth 401(k)
The Roth Individual Retirement Account (IRA) and Roth 401(k) are tax advantaged options in which you make after-tax contributions, your earnings grow tax deferred, and all distributions are tax-free. Some firms offer a Roth option in their 401(k) plans and this is a great one to use. If not, then fund the Roth through an IRA. The only limiting factor with a Roth IRA is the income phaseouts—you must have income below $129,000 as a single filer and $204,000 for those filing married filing jointly in order to contribute in 2022.
5. Taxable Investment Accounts
The final bucket to invest in is a taxable investment account. It’s important to invest in low-turnover, equity investments in this account due to the favorable tax treatment of realized long-term capital gains. The balances in these accounts are free from all distribution restrictions.
The exact order you fill your buckets will be based on your age, tax bracket and if you have a Roth option in your work plan. One strategy around Roth vs Traditional 401k is to contribute to your Roth early in your career and then switch to a traditional 401k in your higher earning years when “pre-tax dollars” are more valuable at your higher tax bracket.
A good goal is to enter your retirement years with healthy balances in your emergency fund, traditional IRA, Roth IRA, HSA account, and taxable investment account. With investments in all of these buckets, you have given yourself options to avoid the high tax situation that too many retirees find themselves in.
All this information is of no value if you don’t pay yourself first and save! The more you save, the further down this list you can utilize to build a diversified pool of account types.