Last updated: 8/5/2023
Getting the basics right is one of the most important things you can do when it comes to investing your money. It's important to know what types of investment accounts you should make a priority over others. This applies to everybody. When I talk to people about investing, I talk to them about their 'Sequence of Investing' and where they should be investing their money first.
I’ll break it down into tiers.
FIRST TIER (Free Money)
Employer Matching Contributions in Your Retirement Plan (401k, etc): If you work for an employer that offers matching contributions in their retirement plan (401k, etc), this should be your first and main priority. In almost all cases, before you do anything else, take full advantage of your employer's matching contributions. It's free money. Ask your human resources department, benefits manager, employer, or your 401k plan sponsor if they have an employer match and how it works. Then take full advantage of any employer matching contributions. Example: If your employer matches 100% of your contributions up to 3% of your income, then make sure you are contributing no less than 3% of your income. Again, it's free money. Make this your priority. Note: If you don’t plan on staying at your company very long (less than 5-7 years), then make sure you ask about the “vesting schedule”. The “vesting schedule” will tell you how long you have to stay at the company in order to keep the employer’s matching contributions. Regardless of the “vesting schedule”, you will always get to keep the money you contribute (plus or minus any investment gains or losses on your contributions).
Employee Stock Purchase Plan (ESPP): If you work for a publicly traded company, there is a good chance they offer employees an ESPP where you can purchase company stock at a discount (typically 15%). A 15% discount is kind of like receiving free money. And if there are no restrictions on when you can sell your ESPP stock, then there is little risk if you sell your shares immediately. You’re basically just pocketing the 15% discount/gain (assuming the spread between your discounted purchase price and your sale price remains 15%). Keep in mind, when you sell your shares, you will likely be subject to ordinary income taxes on the 15% discount/gain. And if you have gains beyond the 15% discount, additional taxes will also apply. But hey, a gain is still a gain. So buying stock at a 15% discount is generally a pretty good deal, but it doesn't come without potential risks. Before you participate in your company's ESPP, you should have a conversation with your financial advisor to discuss the opportunity and risk with your ESPP.
(Click here for more info on ESPPs)
SECOND TIER (Tax-Efficient Accounts)
Roth IRA: A Roth IRA is one of the most tax-efficient accounts available to investors. With a Roth IRA, contributions are made on an after-tax basis (so no deduction going in), but any growth is tax-free as long as you leave the money in your Roth IRA for at least 5 years and you have reached age 59 1/2 (some exceptions apply). By contributing to a Roth IRA, you reduce the unknown risk of what tax brackets might look like in the future. But before you contribute to a Roth IRA, make sure you are eligible. In order to contribute directly to a Roth IRA, you (or your spouse) must have earned income up to the amount you want to contribute…but not too much income or you are ineligible to make a direct Roth IRA contribution (Click here to see the 2023 income limits for direct Roth IRA Contributions). If your income is too high to contribute directly to a Roth IRA, consider the 'Backdoor Roth IRA Strategy'. In 2023, the contribution limit for anybody under the age of 50 is $6500. If you are age 50 or older, the contribution limit is $7500.
Traditional IRA: A Traditional IRA is great if you want to defer/delay taxes. With a Traditional IRA, contributions are generally made on a pre-tax basis (so you can take a deduction going in), but you will owe taxes when you withdraw money from your Traditional IRA in retirement. So it's a way to save on taxes now and pay later. But before you contribute to a Traditional IRA, first make sure you are eligible to contribute…and second, check to see if your contribution can be a deductible contribution. In order to contribute to a Traditional IRA, you (or your spouse) must have earned income up to the amount you want to contribute. And in order for your contribution to be deductible, there are two factors that determine this: your income and whether or not you (or your spouse) are covered by a retirement plan at work (Click here to see the deduction limits for Traditional IRA Contributions). Once the money is in your Traditional IRA, it must stay in your Traditional IRA until you are 59 1/2 or you will be subject to an additional 10% penalty tax for early withdrawals (some exceptions apply). If you are confident you will be in lower tax bracket in retirement, then a Traditional IRA is probably a better choice for you than a Roth IRA. Take the tax deduction now while you're in a higher tax bracket, and pay the taxes in the future when you think you'll be in a lower bracket. Again, this assumes you are eligible to make a deductible Traditional IRA contribution. In 2023, the contribution limit for anybody under the age of 50 is $6500. If you are age 50 or older, the contribution limit is $7500.
Note: You can contribute to both a Roth IRA and a Traditional IRA, but your total combined contributions between these accounts can't exceed the annual contribution limit. The limit is per person, not per account.
Additional Retirement Plan (401k, etc) Contributions: Just because you've taken full advantage of your employer match, doesn't mean you can't contribute more money to your retirement plan at work (401k, etc). The Regular/Traditional 401k offers tax benefits that are similar to a Traditional IRA, while a Roth 401k offers tax benefits that are similar to a Roth IRA. In 2023, the contribution limit for anybody under the age of 50 is $22,500. If you are age 50 or older, the contribution limit is $30,000.
529 Education Savings Plan(s): If you are looking to save money for your child(s) or grandchild(s) education, the 529 Education Savings Plan (aka College 529 Plan) offers a tax-efficient way to do it. A 529 Education Savings Plan is basically like a Roth IRA, but for education expenses. Contributions are made on an after-tax basis (so no deduction going in), but any growth is not subject to federal tax, and generally not subject to state tax, when used for qualified education expenses. 529 Education Savings Plans have high contribution limits based on the annual gift exclusion, which is $17,000 in 2023. And with 529 Education Savings Plans you can make a lump sum contribution up to $85,000 per person if you treat the contribution as being made in equal payments over a 5 year period. To avoid a gift tax, just make sure you don't make any additional gifts to the beneficiary over the next 5 years.
(Click here for more info on 529 Education Savings Plans)
Health Savings Account (HSA): If you are looking to save money for future health related expenses, investing in an HSA is a great option. HSAs offer what’s known as a triple tax benefit. Your contributions are tax deductible. Your money grows tax-deferred while in the HSA. And you can withdraw money from your HSA tax-free as long as it’s used to pay for qualified medical expenses. But before you contribute to an HSA, make sure you are eligible to do so. You must be covered under a qualified high deductible health plan (HDHP) before you contribute to an HSA, along with a couple other eligibility factors. This is very important. Your health insurance agent should be able to help you with any HSA eligibility questions. If your qualified HDHP is for yourself only, you can contribute up to $3850 in 2023. If your qualified HDHP is a family health insurance plan, you can contribute up to $7750 in 2023. If you are age 55 or older, you can contribute an additional $1000.
(Click here for more info on HSAs)
Taxable/Non-IRA Investment Account(s): If you've maximized your options in Tier 1 and Tier 2, and you want to invest additional money, then a regular taxable/non-IRA investment account is likely your next best option. This type of account is also great if you might need access to your money. Maybe you have money that's not for future retirement, education, or health related expenses (although it could still be used for all three). Maybe it's to purchase a vacation property in 5 years or whatever else you may need/want the money for. If so, then a taxable/non-IRA investment account is probably the type of account you need. Since there are no built-in tax efficiencies with this type of account, I suggest using tax-efficient investments to lessen the tax burden. Index Exchange Traded Funds (ETFs) are one of my personal favorites. Index ETFs offer both low cost and tax efficiency. Tax-free municipal bonds might also be a good option. There are no maximum contribution limits with this type of account.
Paying off debt: Should you pay off debt before you invest your money in any of the above listed accounts? It depends. Not all debt is bad debt. Prioritize high interest, non-deductible debt (credit cards, etc)...pay these debts off first. Basically, if the interest rate on your debt is higher than the return you expect to achieve from investing your money elsewhere, then you should pay down your debt before you invest elsewhere. Consider this. When you pay off debt, you are basically guaranteeing yourself a return of whatever the interest rate is on that debt...because you are no longer losing interest to whatever portion of the debt you pay off. That's a guaranteed return that most other investments can't offer you. Generally speaking, I encourage people to pay down any debt where the interest rate on that debt exceeds 6%. If the interest rate on your debt is lower than 6%, then it's more about personal preference. The higher the interest rate is on your debt, the less likely your investments will achieve a return that exceeds the interest rate on your debt. And vice versa. There is one investment where it almost always make sense to invest before you pay down your debt....your employer's match (listed above in tier 1). It's free money. If your employer offers matching contributions, you should probably still prioritize and maximize your employer match before paying off debt. The typical employer match is 50-100% of participant contributions. Unless the interest rate on your debt is higher than the employer match, then maximizing your employer match is probably still the way to go. Just make sure to consider the “vesting schedule” on your employer’s matching contributions (as noted above in tier 1). There are other factors to consider too, such as tax deductibility of your debt's interest, risk tolerance, time frame, your cash flow, etc. Before you make any final decisions, be sure to discuss your situation with your financial advisor.
Life Insurance: Generally speaking, I am not a fan of using life insurance as a way to “invest” money. My motto: Only buy life insurance if you NEED life insurance. So when do you NEED life insurance? Here are four of the most common scenarios where you might NEED life insurance:
- If someone (kids, spouse, etc) is financially dependent on you AND you haven’t saved enough yet to provide for them financially, you NEED life insurance. This is easily the most common need for life insurance. In this case, term insurance will likely do.
- If you have a sizable estate that might be subject to estate taxes, you might need life insurance to pay the estate tax bill. FYI, in 2023, the federal estate tax exemption is $12,920,000 per person (so a married couple could shield $25,840,000). Here, life insurance might keep your heirs (family, etc) from being forced to liquidate/sell assets (land, etc) to pay the estate taxes. In this case, permanent insurance (whole life, universal life, etc) is likely what you need.
- If you are a business owner with a buy/sell agreement in place for business succession planning purposes (which I highly recommend), you might need life insurance on the owner(s) to fund the buyout in the event of an owner’s death. In this case, permanent insurance is likely what you need, but also consider term insurance, depending on the situation.
- If you own a business and have an employee who is key to the success of that business, you might need life insurance on that employee. This is also known as “key man” insurance. In this case, term insurance is likely all you need, but also consider permanent insurance, depending on the situation.
There may be a few other scenarios where you might NEED life insurance, but not many. Again, don’t use life insurance as a way to “invest” money. If your primary goal is long-term investment growth, then a lower cost approach will likely serve you much better. Don't fall for all the sales tricks such as "guaranteed" returns or tax-free loans from YOUR cash value, etc. If it sounds too good to be true, it likely is. Life insurance products typically carry an underlying, hidden cost that far exceeds the total cost of investing in more traditional ways. Know your total cost of investing with life insurance. Ask for a break-down of ALL the costs associated with any life insurance proposal you receive. If your total costs are 2%+ per year higher (very common) in a life insurance policy than a more traditional investment account, do you really think the cash value (your money) of your life insurance policy will produce better long-term returns? Not likely. Fees, expenses, hidden costs, commissions...these don't come from thin air. They are paid by you. Bottom line, don’t use life insurance as a way to “invest” money. Only buy life insurance if you NEED life insurance…and don’t buy more than you need or reasonably expect to need. By the way, if you do NEED life insurance and would like a quote, let me know. I won’t be pushing product on you…we’ll simply have a conversation about what you might need. (Note: With estate planning and business planning, make sure to discuss your situation with a qualified attorney.)
Annuities (Index and/or Variable): Almost everything I talked about with life insurance also applies to annuities. With that said, annuities may make sense if you truly don't mind paying the higher costs and expenses associated with annuities for the added protection some annuities provide. Just know there is a cost for this protection. If you are close to or in retirement, and you are willing to pay an additional 2% per year to have some additional protection on your investments, then an annuity might make sense for you. But make sure you know how much you are paying for any added protection. Ask for a break-down of ALL the costs associated with any annuity proposal you receive (base annuity fee, mortality & expense fee, rider charges, etc). If the person who is trying to sell you an annuity can't explain your total cost or tries to evade this question or downplays the total cost, then you should probably run...fast. If the sales person is totally upfront and transparent, then listen to them and make an informed decision. But don't think 2% of additional cost isn't much. It's a big deal. If the underlying investments in your annuity achieve a 6% per year rate of return, then an additional 2% cost would lower your net return to 4%....or 33% lower than the return you would achieve without the additional cost of the annuity protection. In summary, an annuity might make sense for you. Just know what you are getting in to and make a fully informed decision.
Real Estate: Investing in real estate can be a great way to build wealth. But just like with most investments, some real estate will produce great returns...while other real estate might get you into trouble. Do your homework and expect to spend some time. I suggest talking to several people. Start with people who have been successful at investing in real estate. Talk to more than one so you can hear varying ideas, perspectives, and stories. Talk to your tax advisor so you understand how real estate might impact your taxes. In many cases, investing in real estate can be very tax-efficient. Make sure you weigh the risks and potential rewards. There are far too many factors and variables with real estate for me to get into greater detail here, so don't take this as an endorsement or non-endorsement for any real estate you might be considering. Good luck.
HyLine Bottom Line: Sequence of investing matters. Knowing where you should be investing your money first and what accounts you should be making a priority over others are critical factors in determining your overall financial success.
What can I do at HyLine Wealth to help you with your Sequence of Investing? I can certainly help you decide where you should be investing your money first and what accounts you should be making a priority. I can directly help you with some of the investment accounts listed above. But more importantly, this information is just to help you make better decisions with your money. I hope this helps.
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