Investors who are able to place their investments in several different kinds of accounts (such as taxable accounts, 401k, or an IRA) need to decide which ones to prioritize.
Investing in a prioritized order will maximize the tax efficiency of a portfolio (pay the minimum amount of taxes).
Here is a general account funding priority that often works well for many people (all points will not apply to everyone):
- Contribute to the work-based plan (401(k), 403b,) enough to get the full employer match (the match is like free money, your best possible investment),
- Pay off high interest debt (a guaranteed high return, the next best thing to free money),
- Contribute to a Health Savings Account (HSA) if available (unlike many other tax deductions, there are no income restrictions to contribute to an HSA),[footnotes 1]
- Contribute the maximum to an IRA, traditional or Roth, depending on eligibility and personal circumstances,
- Contribute the remainder of the maximum employee contribution to the work-based plan,
- Contribute to a taxable investing account or use the backdoor Roth technique,[footnotes 2]
- Non-deductible IRAs or annuities.
If the company plan offers good, low-cost funds, it may be preferable to contribute to the company plan before contributing to an IRA.
An investor's tax bracket may influence the decision as well: those in higher tax brackets should consider higher contributions to a tax-deferred plan (e.g. traditional 401k or IRA) rather than a post-tax plan (e.g. Roth 401k or IRA); see Traditional versus Roth for more guidance.
Health savings accounts: Use of an HSA requires participation in an IRS qualified high deductible health plan (HDHP) at work. Look at your particular health care needs to decide if you may be better off with a traditional health care plan or an HDHP plus HSA. If the latter, then using the HSA as an investment account can be advantageous.
Taxable account or backdoor Roth: Most people may find taxable investing more suitable. A backdoor Roth is more suitable for high income taxpayers who are not eligible for direct Roth IRA contributions, have no other traditional IRA assets, and expect to be in a higher tax bracket in retirement.
401(k) plans with high cost funds
Many company plans contain high-cost funds which make them unattractive. If you have such a plan, look for one or two index funds or a bond fund that can be used. If your company offers matching funds up to a certain contribution level, it's always wise to use the company plan. If there is no match, the power of tax-deferred compounding and automatic contributions still favors using the plan with limited contributions.
Also, if you leave your current employer you will most likely be able to rollover the assets in your poor-quality company plan to either a better company plan, or to an IRA.
- Investor should determine if enrolling in a high deductible health plan and possibly gaining access to a HSA is appropriate for their personal circumstances and health care needs. If so, then using the HSA as an investment account can be advantageous and is therefore included in this list.
- This is a technique for contributing to a Roth IRA when your income exceeds the contribution limit. It is complicated in nature and may not be for everyone. Read the Caution section of the article before proceeding and ask in the forum if you are unsure.
- Prioritizing investments- HSA goes where? in Bogleheads.org thread, 16 Feb 2014.