The following is a sample chapter from the guide Investing Made Simple, which is a step-by-step guide through the process of creating an investment plan that helps you reach your biggest personal goals. If you find this chapter to be helpful, you can check out the guide here.
Now that you have your monthly savings target (discussed in the previous chapter), the next big question is: “Where should you be putting it?” Specifically, what types of accounts will make it easiest for you to reach financial independence as soon as possible?
You have a number of options and in this section we’ll walk through the pros and cons of each one.
First Rule: Take Advantage of Tax Advantages
The government has created certain types of savings accounts with built-in tax advantages, and there are a few big reasons why you should generally take advantage of these accounts before looking elsewhere:
- Some of them offer a tax deduction for contributing, which means that you will actually get money back at tax time just for saving.
- Those that don’t offer a deduction DO allow you to eventually withdraw the money tax-free. So it’s either tax-free on the way in or tax-free on the way out.
- They all allow your money to grow tax-free while it’s inside the account, which means it will grow faster than if it were subject to taxes every year.
- Contributing to these accounts may qualify you for the saver’s credit, which can save single parents up to $1,000 and married couples up to $2,000 at tax time.
Basically, these accounts make it easier for you to reach financial independence sooner.
For the most part, what we’ll be talking about here are these different types of tax-advantaged accounts and how you can use them.
Option 1: 401(k) or 403(b) with an Employer Match
If your employer offers a 401(k) or 403(b) with a matching contribution, then that is the place to start no matter what.
An employer match works like this: for every contribution you make up to a certain amount, your employer will match that contribution. In other words, your employer will put extra money into your 401(k) or 403(b) on top of what you contribute yourself.
Here’s a typical example of what an employer match might look like:
- Your employer matches 100% of your contribution, up to 3% of your salary. If you save 3% of your salary, your employer will put in another 3%. You’ve just doubled your money simply by contributing.
- Your employer matches 50% of your contribution above that, up to 5% of your salary. Essentially, you can contribute another 2% of your salary and your employer will match half of that extra contribution.
- You are allowed to contribute more than 5% of your salary, but any amounts above that would not be matched.
In other words, in this scenario every dollar you contribute up to 5% of your salary earns an IMMEDIATE and GUARANTEED 50%-100% return on investment.
That’s a far better deal than you will find anywhere else.
Now, all matching programs will look different, and some employers won’t offer any match. You can request your plan’s Summary Plan Description to find the details about your specific program.
But the moral of the story is this: If your employer offers a match, you’ll want to contribute enough to get that full match before you even think about using another type of account. It’s simply the best deal around.
Quick note: In some cases the employer match will be subject to something called vesting, in which case you would only receive the entire match if you stay with the company for a certain number of years. For example, your employer’s policy might be to increase your vested amount (the amount that’s fully yours) by 20% for each year of employment. In that case you would have to be with the company for 5 years before the entire employer match you have received will be yours.
Option 2: 401(k), 403(b) or 457(b)
If your employer doesn’t offer a match, or if you’re already contributing enough to get the full match and still want to save more, there are a few more variables to consider when it comes to your employer plan.
The 401(k), 403(b) and 457(b) are all different types of retirement plans your employer might offer, but they share a lot of similarities so I’m grouping them together. (Note: I didn’t mention the 457(b) in the previous section because they typically do not offer an employer match.)
One big advantage of these plans is that it should be relatively easy to get started. You can simply ask the Human Resources department about setting up your contribution and it will be taken right out of your paycheck. That’s about as low-hassle as it gets.
Some plans (the better ones) may also have access to lower-cost investment options than you can get on your own. If so, that might be a good reason to prioritize these accounts before others.
Finally, the annual contribution limit here is higher than in any account you can open on your own, so they allow you to save more money. For 2015, the annual contribution limit for these accounts is $18,000.
The big potential downside to look out for here is the cost involved. Some of these plans have lots of fees, and those fees will affect your bottom line. Fees might include the cost of paying an investment manager, the cost of the investment options themselves, and administrative costs —like record-keeping and accounting.
Minimizing the cost of your investments is one of the best ways to maximize return, which is something we’ll be talking about in more detail below. If your employer plan has a lot of fees, you may want to look elsewhere once you’ve secured your employer match.
Summary of Pros
- Easy to get started. Contributions are taken directly out of your paycheck.
- In general, your contributions are tax-deductible in the current year, meaning you will get an immediate tax break. Your eventual withdrawals will then be taxed.
- These accounts may also offer a Roth option, which would not give you a current deduction but would allow you to eventually withdraw the money tax-free.
- High annual contribution limit ($18,000 for 2015). If you are 50 or older, you can contribute an additional $6,000 per year.
- May offer high-quality, low-cost investment options you can’t find on your own.
- When you leave your job, you can take this money with you by either rolling it over into your new employer plan or into an IRA (we’ll talk about IRAs just below).
Summary of Cons
- Some plans have high fees, which will drag down your returns.
- Your investment options are limited to what your employer chooses to include in the plan. In some cases these options may not be great.
- Technically, your money is supposed to stay in the account until age 59.5, but there are some ways around that rule.
Moral of the Story
- Take full advantage of the employer match first, no matter what the plan looks like.
- If your plan offers low-cost investment options that fit your desired investment strategy, this is a good option for your additional savings above that match.
- If your plan has a lot of fees, or if the investment options don’t fit your desired strategy, you might want to contribute additional money elsewhere first.
Option 3: Traditional IRA and Roth IRA
If your employer doesn’t offer a retirement plan, or if you’re looking for a lower-cost option, an IRA is likely to be your best bet.
An IRA is a dedicated retirement account, just like a 401(k) or 403(b). But instead of getting it through your employer, you open it with an investment company of your choosing.
One of the big advantages of using an IRA is that you have a lot more control than you do with an employer plan. You get to decide which investment company you use, which investment options to choose, and which fees you’re willing to pay.
There are two types of IRAs: the Traditional IRA and the Roth IRA. There are several differences between them, but the main difference is in the tax benefit they offer:
- A Traditional IRA works a lot like a traditional 401(k). You get a tax deduction for your contribution, your money grows tax-free inside the account, and your eventual withdrawals will be taxed as regular income.
- A Roth IRA is exactly the opposite. There is no deduction for contributions, but your money grows tax-free inside the account and your contributions will eventually be tax-free.
Essentially, it’s a choice between a tax-deduction today or tax-free withdrawals later.
Both are fantastic options, and the truth is that there isn’t a simple answer as to which one will end up being best for your specific situation. But there are a few rules of thumb that may help you make your decision:
- The higher your current tax bracket, the more likely it is that a Traditional IRA will be most beneficial.
- If your decision is whether to contribute the same dollar amount to either a Roth or Traditional IRA, the Roth will win simply because that money will never be taxed. But keep in mind that you should be able to afford a bigger Traditional IRA contribution because that contribution will save you some tax money.
- Since it’s taxed differently, a Roth IRA can be a nice supplement to an employer 401(k).
- Generally, I tend to favor the Traditional IRA as long as you’re using the tax savings to make a bigger contribution. The exception to that is someone who is already paying very little in taxes.
- Since Traditional IRA contributions lower your taxable income, they can help you qualify for income-dependent tax breaks like the saver’s credit. It may be worth consulting with an accountant or financial planner to understand the specifics of your situation.
- If you’re really not sure which way to go, you could always open one of each and split your contribution 50/50. Best of both worlds.
And again, these are both great options and the truth is that it’s impossible to know for sure which one will end up being better. So, while it is worth putting some thought into the decision, it’s much more important to just pick one and get started.
What Investment Company Should You Open Your IRA With?
Choosing where to open your IRA can be a tough decision, and there are too many options to list them all here.
So I’ll simply say that while I can’t possibly give you a personalized recommendation, and you should do your own research before making any decision here, my default answer would be to open your IRA with Vanguard. It’s the company I use for my personal investments, and the one I end up recommending to most of my clients.
Here are a few reasons why I like Vanguard:
- They basically invented index investing, which is at the core of my personal investment philosophy (we’ll talk more about this later in the book).
- They are investor-focused. Since their founding, Vanguard’s mission has been to provide high-quality investment options to people of all levels of wealth.
- They are dedicated to keeping costs low and have been from the beginning. Given that cost is one of the biggest factors determining your investment return, it’s nice to know that they’re on your side.
There are plenty of other companies that can meet your needs as well, so Vanguard isn’t the only game in town. Schwab is a good one, and Fidelity can be good as well. You could even go with one of the automated investment platforms like Betterment or Wealthfront if you like their investment philosophy.
But for my money, Vanguard is the cream of the crop.
Summary of IRA Pros and Cons
Summary of Pros
- An IRA gives you more control than an employer plan.
- You have more investment options, meaning you can definitely implement your desired investment strategy.
- You can keep costs low.
- You have the option of using a Roth IRA, which may be beneficial depending on your situation.
- You have until April 15 of the next year to make your contributions for the current year. For example, you have until April 15, 2016 to make your 2015 contributions.
Summary of Cons
- As of 2015, your annual contribution is limited to $5,500. If you are 50 or older, you can contribute an additional $1,000 per year.
- That contribution is further limited, and potentially even eliminated, for high-income earners. Here’s an overview of those income limits: http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits.
Moral of the Story
- An IRA is a great way to contribute additional money beyond your employer plan.
- It’s also a great alternative if your employer plan is high-cost or doesn’t offer investment options you like.
- Both the Roth IRA and the Traditional IRA are fantastic options, and the right decision for you really depends on the specifics of your situation.
Option 4: Health Savings Account (HSA)
Many people don’t know about this option, but it can actually be the most powerful place to put your financial independence savings, if you know how to use it.
An HSA is a special type of account that is only available to people with a qualifying high-deductible health insurance plan. For 2015, that means a health insurance plan with a deductible of at least $2,600 for families or $1,300 for individuals.
The HSA is meant to help with the cost of medical expenses, and it provides a few tax breaks to do so:
- Contributions are tax-deductible, just like a 401(k) or Traditional IRA.
- The money grows tax-free while inside the account.
- The money can be withdrawn tax-free for eligible medical expenses.
That’s all pretty cool and can certainly make it easier to handle the cost of your medical bills.
But there are a few more characteristics that ALSO make it a pretty fantastic place to put your financial independence savings:
- The money is 100% yours and rolls over year-to-year, even if you haven’t used it. This is in contrast to a flex-plan you might have at work — which can also help pay for medical bills — where any unused money is forfeited at the end of the year.
- You can invest your HSA money just like you would inside of an IRA, if you choose the right provider.
- While there is typically a 10% penalty in addition to taxes on any withdrawals that aren’t used for medical expenses, that penalty goes away once you reach age 65.
What this means is that if you’re willing to pay your current medical expenses out-of-pocket, you can use an HSA just like a 401(k) or IRA and invest it for the long-term.
In fact, it can be even better than a 401(k) or IRA because it’s the ONLY account that offers a triple tax break:
- Deduction on the way in
- Tax-free growth inside the account, AND
- Tax-free withdrawals for medical expenses
Since we’re all going to have medical expenses when we get older, it’s a pretty safe bet that you will be able to withdraw this money tax-free at some point. And if not, the worst-case scenario is simply waiting until age 65, when you can withdraw the money penalty-free for any reason (just like a 401(k) or Traditional IRA).
So if you have the option available to you, an HSA is a pretty useful place to put some of your financial independence savings.
Where Should You Open Your HSA?
One of the downsides of the HSA is that it can be a little confusing trying to figure out where to open one. It’s something you have to do on your own, even if you have health insurance through your employer, and many of the major banks and investment companies don’t offer them.
Luckily, I’ve already done some of the work for you.
When I do the research for clients, I keep coming back to Health Savings Administrators as the best place to open an HSA if your goal is long-term investing.
While they do have a $45 annual fee (as of this writing), they offer a strong selection of high-quality, low-cost Vanguard mutual funds that is tough to find within another HSA.
If you’re not going to be contributing much, you’ll want to consider another option since that $45 annual fee will eat away at a small balance. But if you plan on making consistent contributions over a number of years, I generally think the fee is worth it.
Still, it’s a good idea to do your own research here and this search tool will help you find a health savings account that works for you: http://www.hsasearch.com/.
Summary of HSA Pros and Cons
Summary of Pros
- It’s the only account with a triple tax-break – Deduction on the way in, tax-free growth, and tax-free withdrawals when used for medical expenses.
- With the right provider, you can invest the money like you would inside an IRA.
- There are no age limits when it comes to tax-free withdrawals for medical expenses. You can do so at any time.
- If you keep good records, you can even use the money to pay for medical expenses from prior years. (The expense must never have been reimbursed or claimed as an itemized deduction previously.)
- Once you are 65, you can withdraw the money for any purpose without penalty. It will be taxed if it’s not used for medical expenses, but in that case it will have functioned just like a 401(k) or Traditional IRA.
Summary of Cons
- If you don’t have a qualifying high-deductible health plan, you are not eligible to open an HSA.
- It can be hard to find an HSA provider with decent investment options, and even if you do those options are limited.
- Some HSA accounts have fees that make them less attractive.
- As of 2015, annual contributions are limited to $6,650 for families and $3,350 for individuals. If you are 55 or older, you can contribute an additional $1,000 per year.
- Before age 65, there is a 10% penalty plus taxes on any withdrawals that are not used for medical expenses.
Moral of the Story
- If you’re eligible to open an HSA, it can be an incredibly powerful way to save for financial independence.
Option 5: Taxable Account
If you’ve exhausted all the tax-advantaged accounts above, the next best place to put your savings is a regular old taxable account. While it doesn’t offer any tax breaks, it does have a few advantages.
The first is that you can invest in pretty much whatever you want. It’s similar to an IRA in that way in that the whole world of options is open to you.
The second is that, again like an IRA, you have a lot of control over how much you pay. You can keep costs to a minimum, leaving more of your money for yourself.
Third, there are fewer restrictions on a regular taxable account than there are on tax-advantaged accounts. Although you don’t want to be dipping into your savings on a regular basis if it’s meant to be set aside for financial independence, the money inside a taxable account is technically available to you at any time for any purpose. (Note: This flexibility can make a taxable account a useful way to fund the early years of financial independence if you get there significantly earlier than typical retirement age.)
Finally, while you won’t get any tax breaks, you can still make efforts to minimize the taxes you pay inside the account. Some examples of that include:
- Using tax-efficient investments like index funds (we’ll talk more about these later in the book).
- Using a buy-and-hold strategy to minimize the number of transactions that might be subject to taxes.
- Tax loss harvesting (see here).
- Tax gain harvesting (see here).
You can open a taxable account with most of the same companies that offer IRAs, so once again Vanguard would be my default recommendation.
Summary of Pros
- Full control over your investment options.
- The ability to minimize costs.
- No restrictions on when you can access the money.
Summary of Cons
- No tax breaks.
Moral of the Story
- Once you’ve maximized your tax-advantaged accounts, a regular taxable account is a fantastic option.
Non-Option 6: Life Insurance
I’m going to keep this short and sweet.
Life insurance is often sold as a way to save for retirement. Insurance agents will wax poetic about the benefits of products like whole life insurance, universal life insurance, variable life insurance, equity-indexed life insurance, and whatever variations they come up with next.
The sales pitch will sound good. It is also, in almost every case, a bad idea to listen to it.
Instead of getting into all the details here, I’m simply going to tell you that 99% of the time you will want to avoid any kind of life insurance when it’s being sold as an investment opportunity. I’ve written about this in extensively on my blog, and you can find all the gory details here.
Now, with that said, there are a few exceptions that I will mention quickly:
- If you already have a whole life insurance policy, you will want to do a little research before you decide to cancel it. A policy that has already been in place for several years is in some cases worth keeping.
- If you are a high income earner and you have already maxed out all of your tax-advantaged space, it is possible to use life insurance as a reasonable investment. But you would need to make sure you work with an agent or financial planner who can design a policy that minimizes agent commissions and maximizes the return you receive. The run-of-the-mill policies most agents sell are not specially designed this way.
- There are some other potential uses for permanent life insurance, such as leaving money for a child with special needs or helping with estate taxes for especially wealthy individuals (generally those with $10 million or more). But those uses are rare exceptions and have nothing to do with investing, so we won’t be going into more depth on them here.
But again, in almost all cases, you will be better off putting your investment money somewhere else. Life insurance is just very, very rarely a reasonable investment option.
Quick note: I do want to quickly mention that I am a big proponent of life insurance as a tool for financial protection, just not as a tool for investing. But in that case you will typically want term life insurance, which will never be sold as an investment opportunity anyways.
Summary: Order of Operations
Whew! That was a lot of information!
So to sum it all up, here’s an order of operations for how you might prioritize your financial independence savings, in terms of where to put your money first:
- 401(k) or 403(b) up to the full employer match.
- HSA, if you are eligible.
- Employer’s plan if it has good investment options and low fees.
- IRA, either Roth or Traditional.
- Taxable account.
This certainly isn’t a golden rule, but it will point you in the right direction.