The Proper Contribution Order Between Your Funding Accounts

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With so many tax-advantaged and taxable investment accounts, it may be hard to figure out the right contribution order. Between our family of four, we’ve somehow managed to open up 14 investment accounts over the years! Thankfully, technology has enabled us to keep track.

If you’re on the path to financial freedom, it’s not good enough to only contribute to a 401(k) and/or Roth IRA. You should also be contributing to a taxable brokerage account and other taxable investments.

After all, it is these taxable investments that will generate the passive income to enable you to leave work before the traditional retirement age.

Without having enough investment income to cover my basic living expenses, I probably would not have left work in 2012. Instead, I would have experienced the one more year syndrome for another five years or so.

The Right Investment Contribution Order

When people ask me what the right contribution order should be, initially, my default answer was to always max out all tax-advantaged retirement accounts first. With cash flow left over, then contribute as much as possible to your taxable investment accounts and other taxable investments.

However, I quickly realized the order of investment contribution is dependent on circumstance. Hence, let me highlight the various scenarios to determine a more nuanced answer.

1) The Default Assumption

When in doubt, always contribute up to the maximum contribution amount in your tax-advantaged retirement accounts. For 2022, this means $20,500 for your 401(k) and $6,000 for your traditional and Roth IRA.

If you are a sole proprietor or small business owner, contribute the maximum employee amount to your Solo 401(k) and then calculate the appropriate employer contribution amount based on your profits. If you are eligible to contribute to a traditional IRA or Roth IRA, please contribute the maximum as well.

The goal is to get in a habit of always contributing the maximum amount to your tax-advantaged accounts and being used to living on post-contribution cash flow. After your maximum contribution amount is complete, then proceed to contribute 20% or more of your after-tax, after-contribution amount cash flow to your taxable investments.

Taxable investments not only include online brokerage accounts, but also private funds, real estate syndication deals, and alternative assets like art, wine, and so forth.

2) The Bear Market Assumption

During corrections or bear markets, it’s easier to sit on your cash and do nothing. However, the risk of doing nothing is that you eventually miss out on a recovery. Therefore, it is recommended to always be contributing something, no matter the market conditions. As the saying goes, time in the market is better than timing the market. Dollar-cost averaging is a fine process, especially if you can keep contributing during downturns.

To make it easier for you to invest in a correction or bear market, contribute to your tax-advantaged accounts first. These include your 401(k), 403(b), traditional IRA, Roth IRA, SEP-IRA, Solo 401(k), and 529 plans. If funds are limited, all else being equal, contribute the most to the tax-advantaged account that is the farthest away from being tapped.

For example, let’s say you are 47 years old with 13 years left to be able to tap your 401(k) without penalty. You also have a one-year-old who is 17 years away from going to college. To overcome your fear of investing, perhaps the right investment contribution order is to contribute the maximum gift tax limit to your child’s 529 plan first. With such a long runway, your chances of having a positive return increase.

Then work to contribute the maximum to your 401(k) throughout the rest of the year, especially if you are above the 24% marginal income tax bracket. It’s easier to invest if you have a longer-term time horizon.

My Example

In 2020, I mustered up the courage to buy a house during the start of the pandemic because I thought about my children. In 20 years, I imagined having a conversation with them about investing in real estate. I imagined they would marvel at how cheap prices were back in 2020 or give me grief if I had not taken advantage during the pandemic.

Investing in a bear market usually turns out well over the long run. However, if you are worried about your job, the right contribution order is to invest in your taxable accounts first. This way, you can more easily draw from your funds if necessary.

3) Different Portfolio Amounts

Of course, the order in which you contribute to your investment accounts is also dependent on the various portfolio amounts. For example, if your 17-year-old daughter has a $300,000 529 plan, while you only have a $200,000 401(k) balance at age 50, it is much better to focus all your contributions on yourself. She is set. You are not.

The only way to know whether you’re on track for your age is to make honest assessments about your future income needs and expenses. I’ve provided guides with:

The portfolio which is furthest behind based on age should get the largest concentration of contribution. And given you should put on your oxygen mask first before helping others, you may want to skip all custodial investment portfolios, custodial Roth IRAs, and 529 plan contributions altogether.

Instead, after you max out your tax-advantaged retirement portfolios, you may want to invest all remaining after-tax, after-tax-advantaged retirement portfolio contributions into your taxable accounts. Although this is less tax-efficient, depending on your deficiency, you should concentrate your contributions for your own financial security.

Once your retirement portfolios are back within a suitable range for your age, you can then proceed to start investing for your kids again. Investing for your kids is a luxury option for most families.

4) The Early Retirement Scenario

If you plan to retire early and have limited funds, then the most appropriate investment contribution order is to build your taxable investment portfolio. Also, work on building your real estate portfolio, and all other non-tax-advantageous investment accounts first.

Given you can’t tap your 401(k) and traditional IRA without a 10% penalty before age 59.5, you need to build your taxable accounts in order to survive off the passive income. However, before you retire early, you should still contribute at least up to the maximum 401(k) match, if you have one. Saying no to free money is unwise.

If you have enough funds to max out your tax-advantaged retirement accounts and contribute to your taxable investments, then you should max out your tax-advantaged retirement accounts even if they are of no use for a while. Your 401(k) and IRA will act as your retirement insurance policy in your 60s and beyond.

And if you get desperate, you can always borrow from your tax-advantaged funds without penalty. Or, you can withdraw from your funds early and pay a penalty.

If you have a reasonable amount of retirement income, but still plan to earn supplemental retirement income after achieving FIRE, then you should open up a Solo 401(k) and contribute as much as possible. Depending on what’s left, I would continue to contribute to your taxable investments even though you are retired.

My Example

When I “retired” in 2012, I forgot to open up a Solo 401(k). I was exhausted and just wanted to go travel. It didn’t even occur to me until mid-2013 that I could have opened one up and contributed $17,000, the maximum at the time. Don’t forget to contribute to a Roth IRA as well if your income is low enough.

Today, my company contributes the most it can to my SEP-IRA. Then I invest over 50% of my after-tax income into my taxable brokerage accounts, venture debt funds, venture capital funds, and real estate crowdfunding. I don’t know how long my supplemental retirement income (online income) will last. Hence, I just reinvest as much of the proceeds as possible in investments that require minimal or no work.

Lean FIRE financial requirements by age chart

5) Buying A House Scenario

If you eventually want to buy a primary residence, as the majority of people do, then the right investment contribution order is trickier. It depends on your income, the current size of the down payment, when you plan to buy, and the cost of the house you want to buy.

First, calculate the house you want and the estimated price. Then you need to accumulate hopefully 30% of the house for a 20% down payment and 10% buffer. This follows my 30/30/3 house buying rule.

Your priority in your 20s should be your career, not buying a home. You’re still discovering what you really want to do. Further, you may go back to graduate school and switch fields. Therefore, the right investment contribution order is to almost always contribute as much as possible to your tax-advantaged accounts first. As you gain more experience, your income should grow to the point where you can max out your tax-advantaged accounts and start contributing to your house fund.

Of course, if you find the perfect job in the perfect city early on, then your priority for buying a primary residence should become a priority. Therefore, you should at least contribute the minimum to your 401(k) to get a 100% match. Then invest as much as possible in your taxable accounts to eventually buy your home.

The closer you get to your house purchase date, the more conservative your investments should be. Here’s an article that discusses more about how to invest your house down payment.

My Example

Immediately, I wanted to buy a Manhattan property the day I started my job in 1999. However, I didn’t have the down payment. As a result, I just maxed out my 401(k) each year, invested aggressively in stocks in my taxable brokerage account, and tried to make more money.

Eventually, I saved up enough to buy my first property in 2003, a condo in San Francisco. Then, I kept maxing out my 401(k) every year and saved between 30% – 80% of my after-tax, after-401k-contribution income as my income grew. By 33, I really wanted to leave finance. Hence, I ramped up my savings and investments to 80%.

6) The Bull Market Scenario

In a bull market, you want to at minimum, max out your tax-advantaged accounts first. Then aggressively invest in taxable risk assets. This is the time to increase your saving rate to a painfully high amount so you can invest as much money in your taxable investments as possible.

Hopefully, you can invest a much, MUCH greater amount in your taxable investments than your tax-advantaged investments. You only need to get rich once. And one of the easiest ways to get rich is during a bull market where bubbles often form.

Therefore, your aim is to also make as much money as possible by job-hopping, starting a business, and working on side hustles. Bull markets don’t last forever. Therefore, you must take full advantage while the going is good.

Always Be Investing

It’s always a good idea to take full advantage of all tax-advantaged accounts. Taxes are a big drag on returns. If you’re just starting out on your financial journey, shoot to accumulate $250,000 – $300,000 in your combined investments. This is the minimum portfolio balance where you start to feel financially free. The momentum really starts building upon itself at this level.

As you gain more experience, aim to accumulate $250,000 – $300,000 in your tax-advantaged accounts only. Then shoot to accumulate $250,000 – $300,000 in your taxable accounts as well. By this point, you will likely gain a lot of motivation to keep on going. Your income will be higher so your investment contributions will go more towards your taxable investments.

Ultimately, if you want to achieve financial independence sooner, try and accumulate 3X more in your taxable investments compared to your tax-advantaged investments. Your taxable accounts have a much higher ceiling. Therefore, you should eventually focus on building these accounts as large as possible.

Readers, what do you think is the right contribution order between investment accounts? What other scenarios are worth discussing to determine the right contribution order?

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