Investment Hierarchy: Top 7 Investments For Retiring Young

When you make the decision to become an early retiree, one of the first things you'll realize is that there are many, many different choices when it comes to investment accounts.  401(k), IRA, HSA, 457, 403(b), Roth, Taxable...the list can get pretty extensive.  Each of these accounts has its own pros and cons and, depending on your unique situation in regard to taxes, timeframe, financial goals, or other factors, one may be more advantageous than another.  However, for the majority of people, I believe there is a clear order in which you should prioritize the placement of your funds across your investment accounts.  Assuming you have a fixed sum of money to invest (if you have an unlimited amount then you should fill them all up!  Also, you should already be retired), here is the order in which you should invest it.

If your employer offers any kind of matching in your 401(k) plan, you should take immediate advantage. Simply put, investing in a 401(k) with an employer match is the best investment out there, period. The rate of matching may vary from company to company but most will offer something along the lines of, 50% match on all employee contributions, up to 6% of your total salary.   That’s FREE MONEY! Deposit the funds into your account and, boom, instant raise. If the matching schedule for your 401(k) plan is a little less generous, don’t fret. As long as there’s some amount of matching, it’s almost always a great investment. Again, Free. Money. You’d be hard-pressed to find any other investment out there with a guaranteed, and instant return. But all that’s only half of the story. 401(k)s also allow you to defer paying taxes on whatever amount you contribute plus any gains, thus reducing your taxable income for the year! With a lower taxable income, your overall tax bill is reduced, which in turn, increases the amount of money you take home, giving you more funds to invest in item number 2! (2019 limit: $19,000; $25,000 for ages 50 and over)

Let’s say you had an investment opportunity available that would pay you 13% a year, guaranteed.  That would be an amazing find worthy of further investigation, in most circumstances. But what if you also had some outstanding debt with an interest rate of 18%?  Pursuing the investment opportunity, as great as it sounds, would end up costing you money.  Your debt would continue to grow at 18% while your investment would be returning "only" 13%.  All things being equal, you’d have a guaranteed net loss of 5% per year, as long as the debt remained unpaid. Clearly, this is a losing situation.  Though not really an investment in the traditional sense of the word, paying off high-interest debt is still one of the most productive ways to use your money.  Every dollar spent provides a guaranteed high rate of return and an instant savings of future funds.   As can be gleaned from the above example, investing while retaining debt doesn't make much sense.  As a result, paying off high-interest debt is the second best "investment" you can make.

Traditional IRA versus Roth IRA.  There are too many arguments to count proclaiming one or the other is the better investment.  So which is actually the best investment for early retirement?  The answer is, it depends. 

All money in a Roth IRA is totally tax-free, forever.  The problem is, you (usually) have to pay taxes on the money before you can get it into the account.  Once you're in early (or late, or any) retirement, the more money you have in a Roth IRA, the better.  While you're still employed, it’s not so clear.  Contributing to a Traditional IRA allows you to deduct the contributions from your taxable income (as long as you meet the workplace retirement plan rules and income limits).  As noted in the 401(k) breakdown, this deduction can provide a huge benefit.  But is the benefit worth trapping all of your funds in an account until 59.5, when you'll be taxed on all withdrawals?  Choosing between these two can be tough, but do not despair.  I have an answer for you.  Well, a few answers to be exact. Based on your circumstances, you should do one of the following:

If you meet all the requirements for eligibility to deduct your Traditional IRA contributions from your income, you should choose a Traditional IRA.  The income deduction is simply too good to pass up.  It may seem like you're gambling on a lower tax bracket in older age but in reality, you should have plenty of time before reaching the required minimum distribution age (70.5 years old in 2018) to convert your Traditional IRA funds into Roth funds (yep, you can do that), minimizing your tax liability.  When it's all said and done, you could end up getting the best of both worlds.

If you find that you are ineligible to deduct Traditional IRA contributions, then go straight for a Roth IRA.  That is, assuming you don't cross the Roth IRA income limit.  If you make so much that you've crossed the Traditional IRA deduction limit and the Roth IRA contribution limit, congratulations on being so well compensated!  There are few valid excuses for you not to retire veeeery early.  If you are in this situation, there is still a way for you to take advantage of an IRA.  You'll do it through what’s called "backdoor" Roth contributions.  The gist is that you contribute non-deductible funds to a Traditional IRA and then perform a Roth conversion on the funds.  Some argue over the appropriate timeline but I believe it's ok to do the conversion the very next day.  (Kitces.com and IRAHelp.com have both written ultra-detailed articles on the topic, check them out to dig further into the details of the backdoor Roth IRA). 

Don't forget to Check out the IRS website for the current income limits and other IRA eligibility guidelines. (2019 limit: $6,000; $7,00 for ages 50 and over)

Note: The tax advantages of traditional accounts begin to fade at lower levels of income. If your income is currently at the lower end of the spectrum a Roth IRA could be right for you. Be sure to run your own numbers (use the examples here) before making your final decision.

Once you’ve fully funded your HSA and IRA, it's time to return to the best overall investment around. We’ve already gone over many of the benefits of a 401(k) so there’s not much to add here.   You’ve contributed enough to get the full match from your employer, now all that’s left is to work towards maxing out your contribution to take advantage of the compounding tax savings i.e. increased 401(k) contribution = reduced taxable income = lower tax liability = increased money in pocket = even more funds to invest. (2019 limit: $19,000; $25,000 for ages 50 and over)

If you have access to any of the accounts above, you should already have several thousand dollars invested before you even begin considering opening a taxable investment account.  For those that have managed to max out all of the accounts up to this point (and pay off all high-interest debt), give yourself a pat on the back.  You are well on your way to a very early retirement.  However, if your circumstances have prevented you from taking advantage of one or more of the accounts but you still have money you'd like to invest, you're in luck.  Taxable accounts have no rules on who can contribute or how much they can deposit (well...very few rules at least).  They also have several unique benefits that some of the other accounts don't offer. 

With a taxable account, you can invest in just about anything.  So whatever security you're interested in, you'll most likely be able to find a taxable account to purchase it through.  In addition, any losses you experience in a taxable account can be deducted when you file your taxes (up to $3,000 per year in 2018; you can carry over any additional losses to future years).  Finally, any long-term (1 year or more) capital gains you capture are taxed at 0%, 15%, or 20%, depending on your tax bracket.  In early retirement, this tax treatment can be EXTREMELY beneficial.  In fact, by properly leveraging this rule, you could potentially avoid paying all income taxes in retirement.  But that's a story for a future article... (limit: Unlimited)

Taxable investment accounts have no spending cap so, in theory, you could skip after-tax 401(k) contributions--not to be confused with Roth contributions--and put everything into a taxable account (after taking full advantage of items 1 through 5 of course). There are some benefits to after-tax 401(k) contributions, however. One of the advantages is that contributions usually happen automatically, via automatic deductions by your employer. This means you never see the money and so it’s impossible to be tempted to spend it. Another advantage is that all gains are tax-deferred just like the rest of your 401(k) savings. Last, and perhaps most beneficial, once you leave your job, you can roll over your after-tax 401(k) contributions directly into a Roth IRA. So every dollar you contribute while employed is actually a future contribution to your Roth IRA. (2019 limit: $56,000; $62,000 for ages 50 and over)

Before allocating any money to investing, you should first consider establishing a solid emergency fund.  If you don't have at least $1,000 in the bank (in a high-yield savings account) you should focus on saving before attempting to invest.  Once you have $1,000 or more saved, you can slowly begin investing.  Start with the top two items on our list.  Invest enough to get the employer match in your 401(k) and work on eliminating high-interest debt.  I'd advise against pursuing any additional investments outside of these two until you've fully funded your emergency fund.  I recommend having at least 3, and no more than 12, months’ worth of living expenses saved for a complete emergency fund.

There you have it! The Official GGD Early Retirement Investment Account Hierarchy. Start at the top and move to the bottom, filling each account with funds along the way.