Investment Accounts for the Modern American Employee

Aaron Hardy
Dec 6, 2019 · 14 min read

Have extra money you’d like to invest? Congratulations! You’re on the first step to securing your financial future. Now that you’ve decided to invest, it’s time to decide which type of investment account to put your money into. If you have sufficient money to invest, you may need to choose several. But which accounts are best? And in what order?

The strategy I outline below is compiled from my own research and experience. I’m not a financial advisor, but I hope you’ll find this valuable.

Decisions, decisions

As a modern employee, you likely have several types of investment accounts at your disposal that are offered by your employer, as well as others available outside your employer. They are not all equal. In fact, there are some extremely important differences to consider.

For this post, we’ll consider the most common account types available to the modern employee which are provided through an employer:

  • Traditional (pre-tax) 401(k)
  • Roth 401(k)
  • After-tax 401(k)
  • Employee stock purchase plan (ESPP)
  • Health savings account (HSA)

We’ll also consider other common account types available to the modern employee, but are not provided by the employer:

  • Traditional IRA
  • Roth IRA
  • Ordinary brokerage

Differentiating Qualities

To determine which accounts you should put your money into and in which order, its important to understand the differentiating qualities. There are many differentiating qualities — too many to cover here — but we’ll cover the most important: employer matching, tax treatment, liquidity, and limits.

If you just want the order and don’t care about the details, feel free to scroll to the bottom.

Employer Matching

The concept is pretty simple — if you put money into the account, your employer will put money into the account. Mostly, it’s an employer’s way of incentivizing you to take care of yourself.

An employer match isn’t always 1:1. For example, an employer might say, “We’ll contribute 50 cents to your account for every dollar you contribute.”

An employer’s match isn’t limitless. For example, an employer might say, “We’ll match your contribution dollar-for-dollar up to 6% of your gross pay.”

Let’s consider the case where an employer indicates they will match 50% of your contributions up to 6% of your eligible pay. Assuming you make $100,000 per year and you elect to contribute 10% of your pay:

$100,000 x 10% = $10,000 ← your contribution
$100,000 x 6% x 50% = $3,000 ← employer contribution
$13,000 ← total contribution

In case this isn’t abundantly clear, the first $6,000 of your contribution received an immediate 50% return on investment (ROI). Do you know which other investment will consistently provide you a 50% return year after year? None. It doesn’t happen. Jokingly, a CEO of mine once mentioned he could tell which employees were good hires by whether they took advantage of the employer match. DO NOT TURN THIS DOWN.

Employer matching is very common for 401(k) accounts. Usually it’s between 50% and 100% matching up to between 3% and 6% of the employee’s contributions, but it varies between companies.

ESPP matching usually comes in the form of a discount on stock price. As an employee, you may elect to contribute a portion of your salary to the ESPP. As each paycheck comes, money is taken out of your paycheck by the employer and set aside. At the end of the purchase period, which is usually six months, the employer takes the money that was set aside and uses it to purchase shares of the company at a discount. You then receive the shares of stock. In many cases, this discount is 15% of the stock price at the beginning of the purchase period or the end of the purchase period, whichever is lower.

For example, let’s say your company’s stock price is $100 at the beginning of the purchase period. Over the six month period you set aside $10,000 for the ESPP. The end of the purchase period arrives and your company’s stock price is now $110. The discount price for each share of stock would be:

$100 x 85% = $85

Your $10,000 can fetch you about 117 shares of stock at this discount price. You can then elect to sell to stock immediately, making a cool $2,870 dollars.

(117 x $110) — $10,000 = $2,870

Alternatively, you can hold on and hope the stock continues to rise.

It case it isn’t clear, the 15% discount alone would be a guaranteed 17.6% return on investment.

$15 / $85 = 17.6%

Do you know which other investment will consistently provide you a 17.6% return over that period of time? Well, 401(k) matching, that’s what. But this is a close second.

For the pedantic reader, 17.6% technically isn’t guaranteed. If the stock price goes down between the time you receive the stock and the time you can sell it, you may not receive the full 17.6% ROI at the time of sale. Statistically, 17.6% should still serve as a worthy estimate.

Employers may match contributions to an HSA, but more commonly the employer will contribute to an HSA regardless of the amount the employee contributes.

These accounts are not provided by the employer, therefore employers don’t offer contribution matching.

Tax Treatment

This is probably the most misunderstood differentiating quality. Uncle Sam likes to pick and choose which money gets taxed and this is an important factor when determining which accounts are most advantageous.

Contributions to a traditional 401(k) or traditional IRA are pre-tax. In other words, you don’t pay taxes on the contribution at the time of contribution. However, for every dollar you withdraw from the account — whether it’s from the contribution or its growth — you pay taxes at that time it is withdrawn. This is also called a tax-deferred account.

Contributions to a Roth 401(k) or Roth IRA are post-tax. In other words, you pay taxes on the money through income taxes before it’s contributed. However, you do not pay any taxes when you withdraw any money from the account. This is called a tax-free or tax-exempt account.

So, when it comes to return on investment with taxes taken into account, which is better— traditional accounts or Roth accounts? All other things being equal, they are the same. They result in exactly the same amount of money for you.

Here’s $10,000 in a traditional account after 10 years of 5% growth per year:

($10,000 * 1.05¹⁰) * 0.75 = $12,216.71

And here’s the same $10,000 in a Roth account:

(0.75 * $10,000) * 1.05¹⁰ = $12,216.71

But all other things aren’t equal. The most important variable here is what your income tax rate is at the time of contribution versus what your income tax rate will be at the time of withdrawal. I emphasize “your” here. You may think the government will raise or lower tax rates, which is important to consider, but it’s not what we’re trying to determine. We’re trying to figure out what your tax rate will be. Here in the USA, we pay taxes according to tax brackets. The more taxable income you have in a given year, the higher percentage of that income you will pay (not just amount, but also percentage). It’s entirely possible that tax brackets rise in the future, but if your taxable income is lower in that year than it is now, you may end up in a lower tax bracket than you are now. This could mean your income tax rate could actually be lower in the future, despite rising tax brackets.

If you believe your income tax rate will be lower in the future when you withdraw from the account, a traditional 401(k) or traditional IRA will provide better results over a Roth 401(k) or Roth IRA. If you believe your income tax rate will be higher in the future when you withdraw from the account, a Roth 401(k) or Roth IRA will provide better results over a traditional 401(k) or traditional IRA.

If pre-tax contributions versus post-tax contributions didn’t confuse you, there’s an account called the after-tax 401(k) that just may. About half of employers offer this type of account.

With the after-tax 401(k), your contribution is post-tax (meaning you’ve paid income taxes on it before the contribution is made) but you also pay taxes on any growth upon withdrawal. On the surface, it would seem there are no tax advantages to an after-tax 401(k).

So why might you consider an after-tax 401(k) at all? As it turns out, money in an after-tax 401(k) can be withdrawn into a Roth account (Roth 401(k) or Roth IRA). Once the money is in the Roth account, the money can then grow tax-free. With some employers, you can set up your after-tax 401(k) to immediately move the money to the Roth account after coming out of your paycheck. This is called an Automated In-plan Roth Conversion. With other employers, you must wait until you leave the employer to withdraw the money into a Roth account.

This strategy of moving after-tax money through an after-tax 401(k) into a Roth account is often called the Mega Backdoor Roth. While the term “backdoor” makes it sound sneaky, there’s nothing sneaky about it; the IRS is fully aware that this strategy exists and has provided official guidance on how to appropriately calculate taxes for it.

Although an HSA is all about health, it has some great investment qualities as well. Contributions to an HSA are pre-tax (you don’t pay taxes on the money before it goes into the account). You can then choose to invest some of the funds inside the HSA, just like you would with money in other investment accounts. All withdrawals from the HSA, as long as they are for qualified health expenses, avoid taxes as well. In other words, the money never gets taxed. From a tax perspective, this makes the HSA quite powerful— even better than a 401(k) and IRA.

Unfortunately, California and New Jersey don’t recognize the HSA from a tax perspective, so citizens of those states must pay state taxes on HSA funds.

These accounts don’t offer any notable tax advantage. Taxes are paid on the contribution amount before the contribution is made. Taxes are also paid on any growth of investments that occur within the accounts. The taxes are paid at the capital gains tax rate when investments within the accounts are sold.

Liquidity

Liquidity, or the ability to access and use money that has been invested, is an important attribute of any investment. An investment may provide a very high return, but if you can’t access that money when you need it, the investment may not provide much value. Just because liquidity doesn’t show up in the numbers does not mean it can be ignored.

Unless covered by one of the several early distribution exemptions, any distribution from a traditional 401(k) or traditional IRA before the magical age of 59 1/2 will result in a 10% penalty. Not only will you have to pay the penalty, but you’ll still have to pay income taxes on the full distribution amount as well.

Roth accounts are more favorable in their liquidity. Because the money you contribute to these accounts has already been taxed, you’re able to withdraw the money you contributed penalty-free as long as your first contribution to the account was at least five years ago. However, if you withdraw more than the amount you’ve contributed, that extra amount will come with a 10% penalty (unless covered by an early distribution exemption).

Similar to the Roth accounts, the money you contributed to an after-tax 401(k) has already been taxed, so you are able to withdraw the money you contributed penalty-free.

There is a difference, however, in how withdrawals are divided between contributions versus growth. In the case of Roth accounts, whenever you make a withdrawal, you’re always withdrawing your contributions first (which are not penalized) and then your growth (which is penalized). As long as you never withdraw more than your contributions, you don’t have to pay a penalty. In the case of an after-tax 401(k), however, any withdrawal must be pro-rated between the percentage of the account composed of contributions and the percentage of the account composed of growth. For example, if you contributed $6,000 to the after-tax 401(k) account and the account is now worth $10,000, the account is made up of 60% contributions and 40% growth. If you decide to withdraw $1,000, you would have to pay a penalty on $400 (40%) of the withdrawal.

Although not technically a withdrawal, 401(k) accounts do allow you to essentially make a loan to yourself. Like other loans, you will need to repay the loan, with interest. Fortunately, the interest goes back into your own account. While a 401(k) loan can be very useful, take care not to take a loan out to pay for frivolous expenditures, but then again that warning applies to all loans.

The idea of limited access to funds from 401(k) and IRA accounts until the age of 59 1/2 may discourage some people from taking full advantage of these types of accounts. For example, some of you may plan on retiring before 59 1/2 and want access to the funds before then. Before you decide to avoid retirement accounts due to this limitation, be aware that there is a penalty-free way to tap into funds within 401(k)s and IRAs in earlier years through the 72(t) rule.

The 72(t) rule states that you can take Substantially Equal Periodic Payments (SEPPs) free of penalty. The amount of each payment is calculating using rules provided by the IRS. Once you begin taking the periodic payments, you cannot change the amount of those payments and you must keep taking the payments for at least five years or until you reach 59 1/2, whichever is longer.

If you only want to receive a portion of your account’s total value through the 72(t) rule, you can create a new account, roll over the desired amount, then use the 72(t) rule to receive SEPPs from the new account only. You can even layer multiple accounts under the 72(t) rule for additional flexibility.

This might sound complicated, but rest assured that if you would like to take money out of a 401(k) or IRA before age 59 1/2, there are options available to you.

An ESPP has relatively high liquidity. During the ESPP period, money is taken out of your paycheck and set aside. When the period ends, the money is used to purchase stock. During the period, if you need to access the money that has been set aside from your paychecks, you can typically withdraw from participation in the ESPP plan without penalty and access the money as soon as your request has been processed.

If the ESPP period has already ended, you no longer have access to cash that’s been set aside but instead own stock. You can sell that stock penalty-free at any time, with the exception of SEC-regulated blackout periods to prevent insider trading.

You can always use HSA funds to pay for qualified medical expenses without paying taxes or penalty on the amount used.

If you withdraw funds out of your HSA for non-medical expenses before the age of 65, you will be required to pay income taxes plus a 20% penalty on the withdrawn amount. Ouch.

After 65, you can withdraw HSA funds penalty-free for any expense, regardless of whether its health-related. If the expense is not health-related, though, you will need to pay income taxes on the withdrawn amount.

With an ordinary brokerage, your money is as liquid as the investments you choose to make inside the brokerage account. Some investments, like stocks, will be quite liquid since you can typically sell them at any time without penalty. Others, like CDs, are longer-term commitments and will be less liquid.

Limits

Unfortunately, you can’t contribute an unlimited amount to each account. Limits exist for some accounts and those limits are typically age-based or income-based.

These limits are according to 2020 tax rules.

The maximum you can contribute to a traditional 401(k) or a Roth 401(k) is $19,500 combined. If you’re 50 or older, the maximum is $26,000 combined.

One of the beauties of the after-tax 401(k) is that you can contribute to it even if you’ve maxed out your traditional 401(k) and Roth 401(k) contributions. The total you can contribute to the traditional 401(k), Roth 401(k), and after-tax 401(k), plus any employer contributions, is limited at $57,000. This is also known as the 415 limit or the “all sources” contribution limit. For example, if you contributed $10,000 to a traditional 401(k), $9,500 to a Roth 401(k), and your employer contributed $5,500, then you can contribute $32,000 to the after-tax 401(k).

$10,000 + $9,500 + $5,500 + $32,000 = $57,000

If you’re 50 or older, the “all sources” contribution limit is $63,500.

The maximum you can contribute to a traditional IRA or a Roth IRA is $6,000 combined. If you’re 50 or older, the maximum is $7,000 combined. This maximum, unlike the maximum for 401(k)s, may be reduced based on your income.

The maximum you can contribute to an ESPP is $25,000 minus the discount provided by your employer. For example, if your employer provides a 10% discount on stock, you can contribute $22,500 to the ESPP.

$25,000 * 90% = $22,500

For individuals, the maximum you can contribute is $3,550. For individuals with a family, the maximum you can contribute is $7,100. Employer contributions also count toward this maximum.

There’s no limit on how much you can contribute to an ordinary brokerage account.

Order of Investing

Now that we’ve broken down the merits of each type of account, the question remains: Where do I put my money!? Here’s the order I recommend.

  1. Traditional or Roth 401(k) up to the employer match
    Get that employer match! The return on investment is too good to pass up. Don’t contribute more than necessary to get the full employer match. We’ll come back to this later. If you believe your income tax rate is higher now than when you will withdraw money from the account, go with the traditional 401(k); otherwise, go with the Roth 401(k). If you’re on the fence about future tax rates, I recommend leaning toward the Roth because of its more subtle advantages (e.g., you can withdrawal contributions anytime penalty-free).
  2. ESPP to the limit
    A guaranteed substantial return with great potential if the stock goes up. The merits of holding or selling company stock after it’s been purchased is a discussion for another day. However, if you need to sell the stock in order to hit the limits on the accounts lower in this list — with the exception of the ordinary brokerage account — I recommend selling.
  3. HSA to the limit
    Unlike #1 and #2, there are no guaranteed returns, but money is tax-free going in and tax-free coming out as long as it’s for health expenses, and that’s pretty great. Think you won’t use it all on health expenses over your lifetime? Remember, you can also withdraw money after you’re 65 for non-health expenses and only pay income taxes on it.
  4. Traditional or Roth IRA to the limit
    Although there’s no guaranteed return and it doesn’t provide quite the tax advantage that the HSA provides, an IRA is still tax-advantaged. We attempt to hit the limit on the IRA before revisiting the 401(k) because the IRA provides more flexibility in investment options (you’re not restricted to the options your employer provides). If you believe your income tax rate is higher now than when you will withdraw money from the account, go with the traditional IRA; otherwise, go with the Roth IRA. Again, if you’re on the fence about future tax rates, I recommend leaning toward the Roth.
  5. Traditional or Roth 401(k) to the limit
    We’re back to the 401(k). This time, load it to the limit to get that tax advantage.
  6. After-tax 401(k) to the limit
    While the after-tax 401(k) doesn’t provide any immediate tax advantage, once you roll the money over into a Roth, it grows tax-free.
  7. Ordinary Brokerage for the rest
    Still have money burning a hole in your pocket? Congratulations! Invest the remainder through an ordinary brokerage account. The tax advantages are slim pickings here, but there’s still money to be made.

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Aaron Hardy

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I am a software engineer at Adobe working on the Launch product, primarily focusing on the Launch runtime library and extension development ecosystem.

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