MintLife Reader Q&A: Direct Investing, IRAs, and 401(k)s – What Order Should I Invest In?

MintLife investing expert Matthew Amster-Burton is answering questions from Mint.com Facebook fans. If you’d like to ask Matthew a question about investing, retirement planning, or saving for college, drop us an email.

MintLife reader Zachary asks:

What are the best types of investments to keep in different types of accounts to maximize returns and pay the lowest taxes?

Direct investing, Roth IRA, traditional IRA, 401(k), real estate? Also, what’s the best place to invest if a 401(k) is not an option and IRA is maximized?

and reader Brandon asks:

Should I maximize contributions to a Roth IRA before looking at other investment options?

Here’s the scoop, gentlemen. “What order should I invest in?” is a fun question.

Because there are so many different options and scenarios to consider, it provides your local columnist with the opportunity to geek out in a big way and build a bunch of spreadsheets.

3 Basic Principles of Investing

I’m going to resist the temptation this time, however (I can hear the boos from the crowd). This is really pretty simple. I can boil it down to three basic principles, no financial calculator required.

1. Get your 401(k) match first.

If you have access to a 401(k) or similar workplace retirement plan with an employer match, contribute enough to get the full match.

If you’ve read any personal finance advice ever in your life, you’ve heard this before, and it’s true.

2. Continue filling your tax-advantaged accounts.

Tax-advantaged accounts are the ones with names, and Zachary did a good job of reeling them off: the 401(k), Roth IRA, and traditional IRA are the most popular.

Add to the list the 403(b), 457, Health Savings Account, and a bunch of other savings vehicles with names only the IRS could love. (Just kidding: the IRS doesn’t know how to love.)

Does the order in which you fill these accounts matter?

It might, but not very much, and the tax code and your personal financial situation are going to change three times each before you retire.

All we can say for sure is that saving beats not saving.

3. Don’t use a taxable account for retirement saving until your tax-advantaged accounts are full.

A taxable account is a brokerage or mutual fund company account that doesn’t have a special IRS-inspired name. All those named and numbered accounts are taxed only when you take money out.

(Except for the Roth IRA, which is taxed only when you put money in.)

A taxable account is taxed annually at various rates which depend on your income tax bracket, what’s in the account, how much money you make on your investments, and how often you buy and sell.

It almost never makes sense to put money in a taxable account when you still have room in your tax-advantaged accounts.

Even if you think you might need the money before age 59.5, there are lots of ways to access tax-advantaged money early without paying a penalty. Here are just two:

• You can always withdraw contributions from a Roth IRA, tax- and penalty-free.
• You can withdraw from a 401(k) at age 55 if you leave your job.

Wrapping up

So, I kind of ducked Zachary’s question. If you’re lucky enough to need that taxable account, it makes more sense to keep certain types of investments in there to save on taxes.

Specifically: stocks usually belong in your taxable account and bonds in your tax-advantaged account. But the actual effect on your tax bill is subtle.

Where should you invest if you don’t have a 401(k) and filled up your IRA? It depends why you don’t have a 401(k).

If you’re an employee (and receive an annual W-2), you’ll probably need to use a taxable account once you fill up your IRA.

If you’re self-employed, however, you can open an Individual 401(k) or SEP-IRA and lower your taxes a lot more.

You should also consider buying I-bonds, which are US savings bonds that are guaranteed to grow at least as much as the rate of inflation.

They can only be held in a taxable account and are a great all-around low-risk, low-return investment with inflation protection.

As for Brandon, go ahead and fill up that Roth IRA—as long as you’ve taken advantage of any 401(k) match first.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.