Let’s face it, the investment world is vast and can be overwhelming even for the experienced investor. You know you should invest for your future; you have money to invest, but where and how to invest is a complicated and daunting process.
Should you use tax-deferred accounts, tax-free accounts, or taxable accounts? How do all the rules of various retirement accounts interplay with each other? What are the tax implications?
Following is a quick guide to help you determine where and how to invest your next dollar earned.
First off, are you financially secure?
If the answer is “no,” then what needs to be done to get you on solid financial footing? Consider paying off high-interest debt, building an emergency fund, and creating a realistic budget. Taking these steps not only saves you money, but can reduce your stress level as well.
If the answer is “yes”, that’s great news as money can provide you with options, but those options also bring complexity. Let’s dive in.
Are you taking advantage of free money?
This is an easy one. If your employer offers a retirement plan such as a 401(k), 403(b), 457 Plan, or other plan options, and offers to match a portion of your contributions, you should be taking advantage of this free money. If you aren’t, you’re throwing away money. If you can afford to contribute enough to take full advantage of any match available to you, you should.
If you work for a publicly traded company, you might have other “free” money sources to tap. See if your employer offers an Employee Stock Purchase Plan (ESPP). This is a company-sponsored program where participants can purchase company stock at a discounted price (many companies offer a 15% discount on the current market price). However, pay close attention to how much of your company’s stock you own, and try to avoid creating a concentrated position in just one stock (a stock that is also linked to your employment).
Don’t overlook these free money options. Just ensure they don’t conflict with other high-priority goals, and make sure you understand any requirements such as vesting schedules, holding requirements, or other potential restrictions.
What are your savings goals?
After you’ve taken advantage of free money, where you go from there depends on your savings goals.
Retirement - If you’re able to save more, and your goals are centered around retirement, consider these options
Contribute more to your employer-sponsored retirement plan, whether pre-tax or after-tax contributions such as a Roth 401(k). Be sure you understand the different tax implications when deciding between plans, and also consider making “catch-up” contributions if you’re over age 50 (as of 2023, this allows you to contribute an additional $7,500 on top of the normal max contribution of $22,500).
Depending on your income level and tax situation, consider contributions to Traditional IRAs and/or Roth IRAs, which, like employer-sponsored plans, allow catch-up contributions for those over age 50 ($1,000 extra as of 2023). Additionally, determine if a “backdoor” Roth IRA contribution or a “mega” Roth contribution makes sense for you. Again, be sure that you understand the tax implications and restrictions surrounding these accounts.
If you’re self-employed, consider contributions to plans such as SEP-IRAs and Individual 401(k) plans. There are other plans available, but if you’re a high earner, these plans will fast-track your retirement savings as both have a 2023 contribution limit of $66,000. Individual 401(k)s provide an extra boost as they allow catch-up contributions of $7,500, making the maximum contribution for the current year a whopping $73,500. Make sure you understand the rules of self-employed plans, as well as the pros and cons, and choose the option that best suits your needs and situation.
Determine if you’re eligible to contribute to a Health Savings Account (HSA). HSAs can be a tremendous savings vehicle for retirement and are available to those with high-deductible health plans. Contributions to the plan are tax-deductible (the 2023 max contribution for a family is $7,750), and withdrawals are tax-free as long as they are used to pay for qualifying medical expenses. For those over age 55, an additional $1,000 contribution is allowed. As a bonus, employers can contribute to your HSA, and the contributions are excluded from your taxable income and are tax-deductible by your employer.
If you’ve exhausted your options for tax-sheltered accounts, or you have money to invest that can’t be subject to the restrictions of most retirement accounts, consider adding money to a taxable brokerage account. Having a taxable account not only comes with zero restrictions on contributions and withdrawals, but it can enhance your tax diversification, providing you with more options when deciding what accounts to tap for income in retirement.
Saving for a short-term goal – If you’re saving for a goal where the money will be needed in less than 5 years, such as buying a home or paying for a wedding, then you may find the restrictions of retirement accounts, or the whims of the vacillating equity markets, unsuitable. With short-term interest rates up from historical lows, consider parking the money in money market funds, CDs, or short-term bonds. If purchasing an investment with a maturity date such as a CD, just be sure to pay attention to the maturity date so the money is available when you need it.
Do you have children (or grandchildren) and want to fund their education? Consider a 529 College Savings Plan. For 2023, an account owner can contribute up to $17,000 per 529 without triggering the gift tax. For a married couple, it’s $34,000. Have a lot of excess cash? Account owners can frontload up to 5 years of contributions per 529, for a total of $85,000 for a single tax filer or $170,000 for married couples filing jointly. If you do this, you won’t be able to make contributions to the plan for another 5 years, but it’s a powerful way to jumpstart college savings. Lastly, check with your state as many states offer a tax deduction for 529 contributions.
Are you charitably inclined? Consider opening a Donor Advised Fund (DAF). Because the standard deduction for 2023 is $27,700 for a married couple filing jointly, fewer people are itemizing their deductions, which means you might not qualify for a tax deduction on smaller charitable contributions. A DAF allows you to “bunch” contributions, which might allow for your contributions to qualify for a charitable deduction. Let’s say you typically donate $5,000 a year to charity but always fall short of the standard deduction limit. This means you won’t receive a charitable deduction in any given year. If instead you “bunch” 5 years of contributions into one, and contribute $25,000 to a DAF, this might push you over the standard deduction and allow you to deduct a least a portion of your donation in the current year. Once the funds are in the DAF, you can make donations to any IRS-qualifying charity (there is no time limit to use these funds, and donations can be spread out over many years or held indefinitely). Just keep in mind that once money goes into a DAF, it must be used for charitable purposes.
What To Do Next?
I hope you found these ideas helpful, and that you feel confident implementing these steps with ease. However, there is no one-size-fits-all solution for savings and investments, so make sure your plan is specific to your circumstances, goals, and needs.
The reality is that as wealth builds, so does the complexity. For many, the multitude of options available, or the fear of making a mistake, can lead to indecision and a failure to plan appropriately for important goals. Or, you simply might not have time to manage all the moving pieces on your own. If you fall into either of these categories, you’re not alone. I routinely guide clients through this complex process, so feel free to reach out to me if you have questions regarding your financial plan (or lack thereof).
Tad Jakes, CFP®, EA