Photo by reidracLet's start with the general rule for prioritizing investment accounts in order to be the most tax efficient. Granted this could differ according to your specific circumstances but generally speaking, this is how things should go down or I guess I should say up since this is investing.
- Employer sponsored plan (401(k) (Roth or Traditional), 403(b), etc) up to the employer match.
- IRA (Roth or Traditional) up to the maximum allowed contributions, as your situation allows.
- Employer sponsored plan up to the maximum allowed contributions.
- Taxable accounts
Here's a quick explanation for why that list is what it is.
First of all, taxable accounts is last because, in case you didn't know, taxes are not your friend. Investing in taxable accounts basically gets you taxed twice. The money you invest is already taxed before you get your paycheck and then any gains that your investment makes are taxed as well. Whereas 401(k) and IRAs are tax-advantaged, meaning you only pay taxes on the front end or back end (Roth or Traditional), not on both.
If both are tax-advantaged why does the order of 1-3 matter? The main reason is because a lot of 401(k) plans offer investment funds that have high fees or are undesirable for other reasons. However, the 401(k) plan stays on top if your company provides contribution matching. That's basically free money so your top priority should be to put in enough to get it. If the 401(k) plan offers solid funds, feel free to max out the account (step 3 before 2), if not, open up an IRA.
The niceness of the IRA is you can invest with whatever company you want and pick whatever investments you want. Also, with Roth IRAs you can take out your contributions at any time without incurring any taxes or penalties from the IRS. So it adds some flexibility, but don't go treating it like a piggy bank. That money should be left in plece to make baby monies so that you have enough to retire some day. After your IRA is maxed out for the year, go back to the employee plan. Once that's maxed out, congratulations. Your reward for saving so diligently? Now you get taxed more on investments, yay you!
The niceness of the IRA is you can invest with whatever company you want and pick whatever investments you want. Also, with Roth IRAs you can take out your contributions at any time without incurring any taxes or penalties from the IRS. So it adds some flexibility, but don't go treating it like a piggy bank. That money should be left in plece to make baby monies so that you have enough to retire some day. After your IRA is maxed out for the year, go back to the employee plan. Once that's maxed out, congratulations. Your reward for saving so diligently? Now you get taxed more on investments, yay you!
Given all that, here's how our investing went down.
When Mrs. K and I started working the first thing we did was opt-in to the company's 401(k) plan. We get a .25% match on each 1% we contribute up to 4%. So we immediately started putting 4% in to get the full match. In case you didn't know, I love free money. Plus with 401(k) contributions you never miss the money because it's deducted from your paycheck before you see it. Alright, 401(k) funded to get the full match, check.
Next up was opening Roth IRAs and funding them to the max. So that's what we did. We use an automatic weekly deduction. Even though we technically can see the money in our paychecks, it's only for a short time before it disappears.
Then we strayed a little from the rules. First we started funding an emergency account. We built that account up to last us six months or so. Then I thought we'd start investing a little in a non-retirement account just so we could have a little money growing that we could access whenever we wanted. Our 401(k) plan originally didn't have many funds that tickled my fancy, if you know what I mean. I mean I didn't care for them, what were you thinking?
Fast forward to today.
That non-retirement account is making our 401(k)s look very sad. Plus, our 401(k) plan now has a new option that let's us invest in whatever we want just like our IRAs. So there really is no longer a reason to hold back on maxing that bad boy out.
In order to correct our jumping of priority 4 over 3, it's time for 100% 401(k) contributions, aren't you excited? I know I am. Over pretty much the rest of the year, our entire paychecks will be going towards maxing out our 401(k)s (assuming they let me do that). No paychecks for the rest of the year, woo-hoo. If only we had followed the rules from the beginning.
Are you following these tax efficient account investing rules? Do you have any other items in your list?
I don't know that I would put so much emphasis on an employer account. I've had good pension plans through my jobs but I have always ended up leaving the job before becoming vested. It's kind of hard to count on staying at the same job for years and years.
ReplyDeleteWith 401(k)s and 403(b)s you still keep the account when you switch employers.
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