Choosing the right accounts for the long-term

We talked about different tax advantaged accounts. While the tax benefits are important, they should not be the only factor to decide which account to put your money in. Let’s look deeper at how you might think about it.

Before you start investing, make sure you set aside funds for emergency purposes (“emergency fund”). These funds should be liquid (not tied in investments that are hard to sell or that can lose value in case of market downturn). Typically, depending on the risk tolerance and circumstances (occupation, housing situation), the rule of thumb is to have funds that could cover 3-6 months of living expenses (including monthly payments for mortgage if you have one). Most people are comfortable that should something happen to their job, they will be able to re-group and find a source of income during this time-frame. In case you do not want to take any chances, you might set aside more  – some would go with 12 months worth of living expenses. You can leave these funds at the FDIC-insured bank account or put them in the Money Market funds (with the recent cuts in the interest rates, both options will pay back just a de minimis amount in terms of returns).

Upon building the margin of safety with the emergency fund, you can start with your savings strategy. Consider starting with the long-term goals – retirement can be decades away, yet by preparing for it early, you can rely on the power of compounding interest to do half of the job for you. Two tax advantaged accounts most suitable for the long-term savings are 401Ks and HSAs (Health Savings Accounts). If you can put the maximum allowed contribution towards each – great. If not, below are the three steps to help you decide.

Step 1:

In most cases, the second place to put your money (after building an “emergency fund”) will be a 401K as most employers offer a match on the amount you contribute up to a certain threshold. The employer match differs employer by employer – it is worth asking about it before you accept an employment offer from the company as this is an important part of the benefits package. Make sure you contribute to 401K up to the employer match if you can (e.g., if the employer matches up to 3% of your earned income, you should contribute 3% to receive the full match). Research done by Fidelity Investments shows that one in five employees do not take full advantage of the employer match – do not leave that money on the table.

Step 2:

Now that you are getting the full employer match on your 401K, you can turn to your HSA account in case you have one / are eligible to have one. Due to triple+ tax advantage of these accounts, they are the better long-term investment vehicle compared to continuing to contribute to 401K. You can put money to the HSA up to the maximum (in 2020 – $3,550 for an individual and $7,100 for a couple younger than 55). Consider investing your HSA dollars if you can afford it: many people are not aware that they can invest their HSA money; according to Devenir research, a startling 95% of HSA account holders use HSAs solely as a typical checking account to pay for the qualified medical expenses.  Yet the better approach could be to pay for medical expenses out of pocket and invest the HSA dollars. Your “emergency fund” – especially if you have a solid one – can give you confidence that you will be able to pay for a surprise medical bill if it comes without the need to sell off your HSA investments. (Just remember that if you pay for the medical expenses out of pocket, you should keep the receipts – the HSA hack is that you can withdraw the equivalent amount from your HSA later if you need and will have proof for IRS that the withdrawal was justified to avoid tax and penalty).

Step 3:

You have contributed to 401K up to employer match, have maxed out HSA and have money left? Congratulations! Now it’s time to go back to your 401K and contribute up to the maximum ($19,500 in 2020 for people younger than 50).

By going through these 3 simple steps, you can be comfortable you are taking full advantage of the tax advantaged accounts offered by your employer.