Investing Order of Operations
When investing, we often don’t think of an order of operations to maximize our investment dollars. But like math class – multiplication and division before addition and subtraction – there is an order of operations to investing. Everybody’s situation will vary to some degree, but most people’s situations will be similar. When discussing the order of operations, we are discussing where people should put their investable dollars first, second, etc.
There are several different accounts one can typically use to invest. Most people automatically think of accounts such as their 401(k) or IRA, but what about other accounts such as a Health Savings Account (HSA) or Employee Stock Purchase Plan (ESPP)? Today we are going to list our opinion on the order of operations for your investment dollars. But understand that this is not specific advice, just general guidance. Please always consult a financial professional before making financial decisions.
1) Employer retirement plan – up to company match: Often employers will offer a dollar-for-dollar company match inside their retirement plan (401k, SIMPLE, etc). If your employer offers a match, this is the first place you should allocate your investable dollars. This is essentially free money or a guaranteed rate of return on your money– depending on your company’s matching policy.
2) Employee Stock Purchase Plan (ESPP): An ESPP usually comes with some sort of company discount, often 15%. If you can sell immediately, you could theoretically buy one day and sell the next day at a 15% gain. This is an easy way to get “free money” as well. Keep in mind that any sale of stock under one year of ownership would create ordinary income tax between the purchase price and sale price. If your company does not offer a discount or the ability to sell immediately, the ESPP would not be the number two option on this list.
3) Health Savings Account (HSA): An HSA is unlike any other account. It is considered triple tax-advantaged – meaning any contributions you make are tax-deductible, contributions/investments grow tax-free, and qualified distributions are tax-free. It’s a perfect account to save and accumulate in for retirement, as your health expenses tend to increase with age. We often see people make the mistake of not using an HSA as a retirement account, and instead, use it to pay for the current year’s health expenses. If you can, cash-flowing health expenses and treating your HSA as a retirement account can save you big in retirement. An additional bonus of an HSA is the ability to avoid FICA tax (7.65%) on the contributions, assuming you contribute through your employer plan.
4) Pre-tax and after-tax 401(k) and IRA: This category is very broad for a purpose. It’s tough to say or suggest which account is better between pre-tax and after-tax. This takes financial planning, expectations for future tax rates, and knowledge of investment returns to help determine what might be the best option.
If you believe you will be in a higher tax bracket later in life (working years or retirement) after-tax/Roth might be the better option. Pre-tax might be the better option if you believe you will be in a lower tax bracket later in life. It’s typically best practice to max out your workplace retirement plan first and then move to your IRAs, but workplace retirement plan costs and investment options can affect this decision as well.
5) Taxable/Brokerage Accounts: The final place to invest money is in a non-qualified taxable account. This account does not provide any tax advantages when contributing to or growing your investments. You pay taxes on any dividends, interest, or capital gains you recognize during the current year. But the advantage of this account is that the long-term capital gains tax rate is always lower than the ordinary income tax rate. Gains and qualified dividends in a taxable account have tax brackets of 0%, 15%, and 20%. A taxable account is extremely beneficial in retirement by providing tax and liquidity diversification. Though it is last on the list, it is not to be forgotten, thanks to its sizable 0% tax bracket, and ability to add tax and liquidity to one’s portfolio.
If you have any comments, questions, or concerns, please feel free to reach out to our Financial Planner, Winston Meyer. His contact information is listed below:
Winston Meyer is a Financial Planner of Invisor Financial LLC, a registered investor adviser firm in the State of Kansas. All opinions expressed are his own and should not be viewed as individual advice. He can be reached at Winston.firstname.lastname@example.org.