A decision that is often faced is “what savings account(s) should I prioritize”?
There are so many options available to you; some accumulation accounts I can think of are:
Checking / Savings cash account
Health Savings Account
Qualified Retirement Account
Nonqualified Retirement Account
Paydown debt / taxable brokerage account
Life insurance is not for accumulation and does not belong in the list. I’ll also leave out nonqualified retirement accounts from my discussion below. These accounts are typically for highly compensated individuals, and can vary in how they are structured. They are too complex for general information and should be reviewed case by case.
The three items that should be reviewed when choosing which account to save are:
Each account ranks high in some of these categories and low in others - that is the give and take that makes the decision personal for each individual.
I will not be breaking down each of the accounts and how they work, but instead how each account should be considered within these three metrics.
One point I want to bring up is that there is also a reason to save into certain accounts for asset protection purposes, but most of my clients don’t run into these issues, so I will be keeping that out. If you feel that you may be in that situation, I suggest you talk to a professional instead of reading a blog.
The variation in all the accounts I mention above largely comes down to taxes. The benefit of choosing one over the other is how it is taxed, and typically needs to be balanced with access and growth to decide which account is best.
If taxes didn’t come into play, you would likely just invest all your money in a “taxable” brokerage account so that you had access to the money whenever you needed it, instead of waiting for retirement or a health event.
But there is a tradeoff with how the account is taxed and the access to it. Getting tax benefits with a retirement account requires you, with few exceptions, to wait until you are at least 59.5 to access the money.
If you need that money in the short-term, those tax benefits will become a tax detriment by becoming taxable and being penalized for accessing that money early.
The best accounts for taxability I would rate:
Health Savings Account - tax deduction for contribution and tax-free withdrawals if all the rules are followed.
Qualified Retirement Account - taxed either up front or at distribution, depending on Roth or Traditional contributions. A benefit is the tax-deferral of any money made in the account.
Taxable investment accounts - this is third because there are no tax deductions for contributions and any income is taxed along the way. But there is some tax planning to help, like the ability to deduct realized losses, keeping investment gains unrealized (by not selling) and there are beneficial tax rates for holding investments for longer than one year.
I point those out because there are definitely situations where taxable investment accounts are more tax efficient than certain retirement accounts - make sure you understand how they operate and what the plan is for the money before choosing which to go with.
You pay for access.
Money that you need in the short term most likely:
Avoids any tax benefits
Should not be invested for growth
That is the tradeoff to have access to your money! This is important when discussing emergency funds for two reasons:
An emergency fund is built for access. You should not be investing that money for growth. Its job is to protect, hold its value, and always be available in the case of an emergency.
The emergency fund’s job is crucial to allow other assets to grow and have tax benefits. The fund buys time so that other assets can be invested in retirement accounts or HSAs, and there is a line of defense before you have to access any of this money.
Emergency funds are the unsung hero that nobody wants until they need it. Make sure you show your appreciation to your emergency fund by keeping it topped off and happy.
My ratings for the best accounts for access are:
Taxable accounts - this is money you’ve already paid tax on and is immediately available to you. No penalties or taxes for withdrawing or spending this money (unless you sold investments to get the cash, there would be some tax).
Roth IRAs - I want to make a point that any contribution into a Roth IRA is always accessible tax and penalty free. Note that I specify both IRA (not Roth 401(k)) and CONTRIBUTIONS. If you make any money in your Roth and distribute those earnings early, it will be taxed and penalized (with few exceptions).
Health Savings Accounts (probably) - I would suspect you’ll have some health events prior to 59.5 years old that will allow access to your funds in this account.
(Other) Retirement Accounts - as I’ve said many times, wait until age 59.5 before you have full access to these dollars, with certain exceptions I won’t get into on this post.
Finally, the last metric is growth, which I am suggesting to determine if the account can be invested and grow for the long-term.
There isn’t really an order of best or worst within this category, as most accounts can be invested, including:
Health Savings Accounts
All retirement accounts
Taxable brokerage accounts
Each of these have different options, and you can make a case that taxable brokerage accounts or IRA accounts are best because you have the whole investment universe, whereas HSAs and employer sponsored retirement plans may have limited options. But at the end of the day, they can all be invested for growth.
Checking and savings accounts cannot be invested and therefore the access and store of value of these accounts is the tradeoff with not having growth.
Growth and accessibility go hand in hand - typically if you are focusing on long-term growth for that money, you’ll want something LESS accessible because that will bring added benefits like tax-deferral and compounding interest.
Now if you made it to the end of this blog, that is great! You read a lot about how these accounts work, but unfortunately no great actionable advice.
I would love to give you direct advice, but unfortunately everybody is different. For a person who has extra savings capacity and doesn’t know what to do with it, here is the order of operations I might suggest:
Pay off high interest debt
Build emergency fund
Get employer match, if available
Max out HSA
Fund all other qualified retirement accounts
Consider nonqualified accounts (not always a no brainer)
Depending on your cash flow, many of these can work alongside each other, and one does not have to be achieved before moving onto the next. For example, I may suggest you get your employer match as you build your emergency fund, if your income allows.
Notice I did not put in there to save in a taxable brokerage account / added funding of checking and savings accounts. This is where the variability comes in, and saving in those accounts can be sprinkled in everywhere and anywhere depending on what your goals are. Some may want to prioritize after-tax savings because they are:
Buying a house
Starting a family
Starting a business
In the year I was planning on starting Pocket Project, I didn’t save a single dollar into my 401(k) because I did not want to give up access to that money. This money was (and continues to be) crucial to the survival of my business by funding my living expenses during a time of no income. I did contribute to my Roth IRA and kept it in cash so that I could access that money again if needed. Clearly, my priority was access above tax advantages or growth during this time.
I also excluded some accounts and strategies for specific life stages, like:
529 Education accounts
Trusts or other legacy planning
These can all be worked into the equation for individuals or families with these specific goals - each has its own place depending on priority and time horizon for those goals.
I have avoided writing this blog because there are so many “maybes”, “it depends”, etc. The point I want to portray is this:
Each account has its own features. Make sure you know these features and are the features you want for your specific strategy / goal for that money. This can save you a lot of money in taxes, fees and short-term investment losses.