Optimize Investments Across Account Types

The following is part of our 21 Days to Improve Your Financial Life special report.

There are a lot of reasons so many Americans are hurtling toward a retirement savings shortfall--or dealing with one already.

The most obvious, of course, is that so many household budgets are strained, making it difficult to set aside additional assets for retirement savings. There's also the fact that more than half of workers older than 22 don't have a workplace retirement plan to contribute to.

Another possible factor--albeit more minor than those two biggies--is the sheer complexity of our system for tax-sheltered retirement savings. There are IRAs as well as company retirement plans like 401(k)s, 457 plans, and 403(b)s; investors also have to choose between traditional contributions and Roth. Self-employed individuals have an even more dizzying array of options to choose from--solo 401(k)s, SEP IRAs, and SIMPLE IRAs, to name just a few. And then there are nonretirement vehicles that can be used for retirement savings, like health savings accounts. All of these options come with their own tax treatment and rules about contributions and withdrawals. Selecting investments can seem daunting unto itself; some investors are likely confused about where to hold those investments in the first place.

To be sure, optimizing your investments across various financial accounts is more art than science: It depends on how much you have to invest, your income, what types of tax and other incentives are available to you, and the quality of the investment options available, to name some of the big swing factors.

As you decide how to allocate your dollars across your choice set, here are the key steps to take.

Step 1: Take stock of your tool kit and eligibility. Start by assessing which retirement savings vehicles are available to you given your income and the amount you have to contribute.

As long as you (or your spouse) have enough earned income to cover your contribution amount, you'll be able to make a contribution to at least some type of IRA, whether Roth, traditional deductible, or traditional nondeductible; this article outlines the income limits that govern each type. Anyone with earned income can make a traditional nondeductible IRA contribution--there's no upper limit on income, in contrast with Roth and traditional deductible IRAs. Yet traditional nondeductible IRAs usually don't make sense as buy-and-hold vehicles, as discussed here.

In addition, take stock of whether your employer fields a retirement plan. While some plans may feature extra layers of fees and subpar investment options--more on this below--they typically allow for generous contribution limits regardless of income and may also offer matching contributions. Moreover, company-provided retirement savings plans offer built-in discipline, extracting money from your paycheck and investing it in the market on a regular basis.

If you're self-employed and/or don't have a company retirement plan available to contribute to, take stock of self-employed investment options, as outlined here.

Step 2: Investigate company matching contributions. If you're eligible to contribute to a company retirement plan, check to see if your employer is matching employees on their contributions. Even if a company's match is lackluster--say, $0.25 on every dollar invested--it's going to be difficult to out-earn that rate of return by investing outside of the 401(k) (or 403(b) or 457 plan). And remember: Those matching contributions are in addition to any investment earnings. If you're earning matching contributions, plan to contribute at least enough to earn the match.

Step 3: Investigate quality of company retirement plan. One key virtue of investing in an IRA is that you can keep almost anything inside of it; you also have leeway to invest in very low-cost investments and administrative fees are usually low or nonexistent. By contrast, your company retirement plan is apt to hem you in a bit; you'll typically be required to choose from a constrained list of investments, and the plan may feature an extra layer of administrative expenses that you could avoid by investing in an IRA.

For those reasons, it's worthwhile to conduct a bit of due diligence on your company retirement plan before sinking any more than matching contributions into it. Among the key items to check are the fees that the individual funds are charging, the quality and breadth of the investments in the plan, and any administrative expenses that are levied on participants. Use this checklist to evaluate the quality of your plan. If it's not up to snuff, you'll still want to put in enough to earn the match; you can then turn to an IRA for additional assets you have to invest. You can go back and contribute additional assets to the lackluster 401(k) once you've maxed out your IRA; the tax breaks associated with a 401(k)--even a lousy one--will tend to beat sinking the same amount of money in taxable account, on an aftertax basis.

Step 4: Assess tax breaks. The next step is to take stock of the tax treatment for each vehicle type you can contribute to. With tax-sheltered retirement-savings vehicles, you'll typically receive a tax break on the way in (you can make pretax or tax-deductible contributions to "traditional" retirement vehicles) or on the way out (with Roth vehicles, qualified withdrawals will be tax-free). You'll also receive tax-deferred compounding on your money--that is, you won't be taxed on any income or capital gains from the assets as long as the money stays inside the tax-sheltered wrapper. (A health savings account, while not explicitly geared toward retirement savings, is the only vehicle that allows for tax breaks at all three levels: pretax contributions, tax-free compounding, and tax-free withdrawals.)

But are you better off taking the tax break upfront (traditional IRAs and 401(k)s) or later on (Roth)? This article discusses some of the key considerations to bear in mind; for many investors, it makes sense to split contributions across both account types.

Step 5: Consider need for early withdrawals. Is there a chance you'll need to pull your money out prior to retirement? If so, favor the investment accounts that give you the most leeway to pull your money out without triggering additional penalties. Among tax-sheltered vehicles, Roth IRAs provide the most flexibility, in that contributions can be withdrawn at any time and for any reason without taxes or penalty.

Step 6: Optimize your allocation based on your choice set and how much you can invest. Armed with the preceding information, you can then allocate your future dollars across the option(s) that gives you the best combination of features. The following hierarchy will make sense in many instances.

Priority 1: Invest enough in 401(k)/other company retirement plan to earn matching contributions. Why prioritize it: To take advantage of free money. De-prioritize if: Your 401(k) offers no matching contributions. In that case, proceed directly to Priority 2.

Priority 2: Invest in an IRA. Why prioritize it: Low costs, flexibility, the ability to contribute to a Roth. De-prioritize if: Your company retirement plan features all the bells and whistles, including ultralow costs and a Roth option. Alternatively, if you need the legal protections of a 401(k) or your situation fits one of those described here. In any of those instances, contribute the maximum to the 401(k) before funding an IRA.

Of course--and here's one of the big exceptions to the hierarchy--some 401(k) plans are rock-solid, featuring no layer of administrative expenses, extra-low-cost investment options, and a full range of features, including the ability to make Roth contributions. If your 401(k) plan ticks all of those boxes, you can go ahead and make a full 401(k) contribution before moving to an IRA.

Priority 2a: Invest in a spousal IRA. Why prioritize it: Amass retirement savings for nonearning spouse. De-prioritize if: The 401(k) of the spouse with earnings is rock-solid; in that case, fully funding that 401(k) plan could reasonably come before funding IRAs for either spouse.

Priority 3: Invest in company retirement plan up to the limit. Why prioritize it: The ability to enjoy tax-free contributions and tax-deferred compounding (traditional), or tax-free compounding and withdrawals (Roth). De-prioritize if: You have plenty of assets in accounts that will be taxed upon withdrawal and you're close to retirement. If that's the case, you may want to prioritize saving in a taxable (nonretirement) account instead of maxing out the company retirement plan. Ditto if there's a chance you'll need the money before retirement.

Priority 4: Invest in a health savings account for retirement. Why prioritize it: HSAs offer a three-fer from a tax standpoint: pretax contributions, tax-free compounded, and tax-free withdrawals for qualified healthcare expenses. Thus, they can be excellent ancillary retirement savings vehicles for investors who have the wherewithal to cover their healthcare expenses with non-HSA assets. De-prioritize if: Your HSA is expensive and/or the long-term investment options are subpar. (Remember you have an escape hatch, however, in that you can periodically transfer assets from your employer-provided HSA to the HSA of your choosing. This article discusses this strategy.)

Priority 5: Make aftertax 401(k) contributions to the limit. Why prioritize it: The ability to enhance a portfolio's share of Roth assets, eventually--provided the 401(k) plan allows for the contribution of aftertax dollars. De-prioritize if: The 401(k) is especially poor, as discussed here.

Priority 6: Invest in taxable account. Why prioritize it: You're aiming for tax diversification in retirement and already have a sizable share of your assets in tax-deferred and Roth accounts. Ditto if there's a chance you'll need to take out your money before retirement or you expect to be in the 0% tax bracket for capital gains when you withdraw your money. De-prioritize if: You haven't yet taken advantage of tax-advantaged accounts that are available to you and you have a long time horizon for your money.