There is no one-size-fits-all solution for most financial questions, but this particular one comes up a lot and, in many cases, is simpler than it might first seem: How do I prioritize contributing to retirement accounts versus paying off debts or investing in taxable space? Before we get to the core options, however, it is worth noting that in most cases your number one priority should be an emergency fund – something to consider before seeking to meet your intermediate-term obligations or far-future financial needs.
1) Match Your 401K: while employed-matched contributions do not universally come first, they should much of the time. After all, matched money means free money – an even match up to a certain percent means doubling your invested sum before you get started.
- Exceptions: If you have extremely high-interest debt on, say, something like credit cards, it might be worth paying this down first. How high? There is no single answer, but a rule of thumb might be 8% to 12% or above.
2) Pay Down Your Debts: at this stage, it is wise to consider other mid-level debt obligations you might have – a ballpark or general rule might be: anything above 5%, or, more conservatively, anything about 3%, which is the approximate long-term inflation rate (meaning: statistically, paying down debt below 3% is not worth doing, as the interest is nominal and not real).
- Exceptions: If you have large cash reserves and feel comfortable taking the risk, you could consider putting this option in third place. Why? Well, Roth IRA space is limited, and you don’t get to go back and fill it up later – what you get yearly is what you get.
3) Invest via a Roth IRA: these unique vehicles are particularly advantageous to those in lower tax brackets, since they accept post-tax funds and then grow and can be withdrawn from tax-free forever (say, when you are later in a higher tax bracket). This fact, coupled with the low limits on contributions compared to 401Ks, make them valuable space in general as well as in terms of tax diversification (hedging your bets about your unknown future retirement tax rate).
- Exceptions: If you have a high income, but not quite high enough to be ineligible for a Roth contribution, you might consider whether you expect to earn more or less in retirement and factor that into your decision-making process.
4) Contribute More to your 401K: at this point, we come again to your core retirement fund – if you have money left over to invest for the long haul, this is likely the place to do it, assuming that there are reasonable- or low-cost funds available that meet your needs.
- Exceptions: If the fund offerings are incomplete with respect to your portfolio goals, you may want to consider investing in a taxable account instead in the short term, and petitioning your employer to offer better options in the future.
5) Invest in a Taxable Account: finally, we come to taxable investing space. This is the last leg of the journey in more ways than one, as it should also be the place your most tax-efficient funds or other investments go after you have placed the more tax-inefficient ones in tax-advantaged spaces. Consider carefully what you buy and whether you can hold it for the long haul, because unlike retirement accounts, selling here means realizing a gain.