Prioritizing investments

🇺🇸

Investors are faced with a variety of choices on where to invest their money; for example, a taxable account, a 401(k), or an IRA. Knowing which accounts to invest in first will maximize return with a minimum of taxes. Prioritizing investments indicates the appropriate order in which investments go into these accounts.

Take care to ensure that any investment priority decision aligns with your Investment Policy Statement.

Funding priority
Here is a general account funding priority that often works well for many people (not all points will apply to everyone). Refer to Figure 1.


 * 1) Establish an emergency fund to your satisfaction. If you have many other high financial priorities (like paying off high-interest debt), start with a smaller emergency fund, and grow it later over time, as those other priorities are satisfied.
 * 2) Contribute to an employer retirement plan (for example, 401(k) or 403b) enough to get the full employer match (the match is like free money, your best possible investment).
 * 3) Pay off high-interest debt (a guaranteed high return, the next best thing to free money).
 * 4) Contribute to a Health Savings Account (HSA) if a high deductible health plan is appropriate for your needs (you can think of HSA contributions as also getting a match, from the IRS).
 * 5) Contribute the maximum to an IRA, traditional or Roth (or  backdoor Roth technique), depending on eligibility and personal circumstances. (See  below for situations where you may prefer to swap steps 5 and 6.)
 * 6) Contribute the remainder of the maximum employee contribution to the work-based plan.
 * 7) If your plan supports it, employ the mega-backdoor Roth strategy.
 * 8) Pay off medium-interest debt (for example, student loans, car loans, and personal loans), especially if the interest is not tax-deductible.
 * 9) Invest inside a taxable account.
 * 10) Pay off low-interest debt (for example, most mortgages, and some car loans).

It is important to realize that these steps are not cast in stone. The above list should be considered with some flexibility for your needs and personal preferences.

Choosing between an employer retirement plan and an IRA
If the company plan offers good, low-cost funds, it may be preferable to contribute to the company plan before contributing to an IRA; see: Comparison between IRAs and employer plans.

Also, your marginal tax rate may influence the decision: those subject to higher marginal tax rates should consider higher contributions to a tax-deferred plan (for example, traditional 401(k) or IRA) rather than a post-tax plan (for example, Roth 401(k) or IRA). See Traditional versus Roth for more guidance.

If you prefer traditional to Roth, and traditional contributions to the employer's plan are needed to reduce your Modified Adjusted Gross Income (MAGI) for traditional IRA purposes enough to allow a full or partial IRA deduction (see IRA Deduction Limits), consider swapping steps 5 and 6.

Rationale for funding priority
Table 1 describes the rationale for investing in the order shown above.

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 is 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.