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Savings Vehicle Allocation
Much has been written about asset allocation. Large cap versus small cap, domestic versus international, growth versus value. The attention to asset allocation by the investment industry is strong and constant. But what saving allocation? Where should your hard-earned savings be located in the first place? This process often feels counterintuitive. The common approach is to place a few percent of your salary in your 401(k) at work and the rest in a self-managed brokerage account or given to a financial advisor to manage in a brokerage account. This common approach leaves a lot on the table as you will see.
Sequential saving is a laddered general template useful in placing your savings where they can work the hardest for you. The tax code is extensive and overwhelming, but the benefits of selecting the proper vehicle for your savings can make a difference as large as 48 years’ worth of annual contributions over a 30-year period. As you are aware, the cornerstone of this sequence is having a strong foundation which means eliminating high interest debt and building a suitable emergency fund so that your investment growth is never interrupted by unexpected turbulence. Once the foundation is built, there are several accounts to examine alongside your personal goals to determine where to allocate your savings.
You do not care about the technical tax differences of the accounts (and if you do I have plenty written on the details found at the links above) so let’s look at the dollar impact at the end of the day. Let’s say you have $5,000 today to contribute to either a Health Savings Account (HSA), a 401(k) with a 30% employer match, a ROTH IRA, or a taxable brokerage account. You have decided that any tax savings you receive for making the contribution will be used to increase the contribution to that account. Assuming a 22% tax rate and a 30% employer match on your 401(k) contribution your total contribution would look like this.
At the end of the day all that matters to you is the after-tax value of your account. If your account shows a $1,000,000 balance but upon distribution 40% of the balance will go to the IRS, your true account balance to you is $600,000. Let’s pretend you were to open these four accounts and make the above contributions all in one year. You then went sleep for 30 years never making an additional contribution or taking a distribution. Each account is invested the same and produces a 7% annual return. After 30 years of growth and settling up with the IRS you would wake up to the following projected balances.
|Taxable Brokerage||ROTH IRA||Traditional 401(k)||HSA|
|Projected After-Tax Value||$28,314||$38,061||$47,085||$49,350|
Why the large difference? The HSA contribution generates an income and payroll tax deduction, the earnings grow tax free, and qualified distributions are never subject to tax. The only advantage the 401(k) has over the ROTH IRA when tax rates are constant is the employer match which at 30% puts the 401(k) on a similar playing field as the HSA. The taxable brokerage account does not offer any of these tax benefits. Earnings such as interest, dividends, and capital gains are subject to tax when they are earned slowing the accounts ability to compound.
30 Years of Consistent Contributions
What if you were to allocate $5,000 to the above accounts every year for 30 years? That would be a total of $150,000 out of your pocket into the account plus any tax savings due to the contributions and employer matches. The story is the same, but the gap widens. The projected after-tax difference between the taxable brokerage account and the HSA after 30 years amounts to $240,063!
Taxable Brokerage Account Benefits
While the above comparisons are true and relevant, there is one benefit to taxable brokerage accounts, flexibility. Taxable brokerage accounts have no limitations on when or how you can use the funds. HSA dollars must be used/reimbursed for medical expenses. The 401(k) cannot be distributed penalty free until age 59½ or some other narrow exception is met. The ROTH IRA allows distribution of prior contributions at any point tax and penalty free but to distribute the entire account, including the growth, the owner must be 59½ or meet other penalty exceptions.
However, flexibility can also encourage poor investing behavior interrupting compounding by taking distributions during the 30-year period. If you are going to need these funds over the next five years, it might not make sense to invest them in the stock market to begin with. If you think you might need the funds over the next 5-15 years maybe the ROTH IRA is the best vehicle allowing you to distribute your previous contributions anytime.
While there are ways to reduce the tax impact of brokerage accounts through loss harvesting or donating appreciated securities, the best place for your long-term stock market investments is rarely ever in a brokerage account. Consider your investing objectives, your ability to utilize the HSA, 401(k) or ROTH IRA, and your time horizon for your annual savings. Thinking about allocating savings in a sequence helps me to move step by step and I hope you find it helpful as well.