Whether it's for retirement, a child's college education, or a dream vacation, the reasons we need to save seem endless. Then there are the places to save money, which seem endless as well. There are Roth IRAs, regular IRAs, 401(k)s, health savings accounts, 529 college savings accounts, and regular taxable mutual funds, to name a few. In an ideal world, this wouldn't be a problem; you'd simply throw some money at each of these accounts, kick back, and watch it grow. If only.
The reality for most people is there's a limited amount of money to go around. That being the case, when it comes to long-term saving, we need to be highly selective on where we put our money to get the most bang for our buck in tax advantages and growth. In other words, we need to prioritize!
So where do we start? In which accounts do we put our money first? What debt do we need to pay down? JPMorgan Chase's 2019 Retirement Guide lays out a hierarchy of how best to allocate your money for the long term (college excluded). Here's what you need to know.
1. Emergency reserve fund
The first place to save is in an emergency cash reserve fund. Some may gloss over this and go right for the 401(k) or even pick a few high-flying tech stocks, but this is short-sighted. Your No. 1 priority is to have three to six months of living expenses as an emergency cash reserve in a safe liquid account, like a checking or a money market account.
The reasons for this are twofold: You won't have to sell other investments like stocks at the wrong time, such as when they are at a loss or incur taxes if sold for a gain; and you won't incur early withdrawal penalties, as you could if you take your money out of an IRA or 401(k) prior to age 59 1/2 to pay for an emergency expense.
Granted, there are hardship exclusions for accessing money early from an IRA or 401(k). You may have the ability to take a loan from a retirement plan, but it's generally not a good idea to raid a retirement account to meet emergency expenses like a car or house repair. Not only is this because of the taxes and fees that you may incur, but also you may never pay back your retirement account, which wouldn't bode well for your long-term retirement goals.
There are many other places to save for an emergency fund, but the bottom line is to get this going, if you haven't already. Try setting aside a little per month or per pay period until you get your emergency fund up to three to six months of expenses. Once it is fully funded, then there are many more interesting places to save, such as accounts that offer free money.
2. Health Savings Account
The next most important place to save, second only to an emergency fund, is a health savings account (HSA) that offers an employer match. An employer match is when the company throws in a few extra bucks to your account to incentivize you to save -- and because they get a tax deduction. An employer match is like free money, it's hard to pass that up.
But what's really surprising is an HSA is a higher priority than a 401(k), according to JPMorgan Chase's Retirement Guide. If this is news to you, consider the tax advantages. An HSA is the only account that offers the holy trinity of tax advantages -- tax-deductible contributions, tax-free growth, and tax-free distributions for qualified medical expenses. A 401(k) offers only two of the three, a tax-deductible contribution and tax-free growth -- still beneficial but not as huge as the HSA's trifecta.
Keep in mind an HSA is available only for those with a high-deductible health insurance plan. Money in an HSA can be withdrawn tax- and penalty-free at any age for qualified medical expenses such as prescription drugs, eyeglasses, and co-insurance payments for doctor visits. Beyond the tax advantages of an HSA, there's another important reason JPMorgan Chase lists an HSA with a match higher than a 401(k), and it has to do with our future medical bills.
Healthcare is expensive by today's standards, let alone what it's projected to be in the future. By Fidelity's estimate, a 65-year-old couple retiring today will need $280,000 for healthcare-related expenses in retirement. That's a substantial amount of money that an HSA can help fund, especially if there is an employer match.
This also means if you fund an HSA, try to not to use it for current-year medical bills, but pay for those expenses out of cash flow. This way, the money in the HSA continues to grow to cover healthcare expenses in retirement. You can also invest money in an HSA, as most offer a lineup of mutual fund choices like a 401(k), generally after you meet a certain minimum, such as $50 per fund. It's best to ask your HR department if your company offers an HSA, and if there are a match and investment options. Keep in mind that JPMorgan Chase's guide recommends funding an HSA only up to the employer match. Then consider other priorities, such as the 401(k) up to the match. (See below.) For more on what a HSA covers, as well as the 2019 annual limits and exclusions, see Motley Fool's Make the Most of Health Savings Accounts.
The grand dame of all retirement plans, the 401(k), is the most popular one offered by large employers and is third on JPMorgan Chase's priority list, but only if there is a match. Like the HSA with a match, JPMorgan Chase recommends funding a 401(k) up to what your employer contributes to get that free money. It's best to check with your HR department about the match and the limit. This is important, as not all 401(k) plans offer a match.
All 401(k) plans do, however, have two powerful income-tax advantages. Money contributed to a 401(k) is tax-deductible, meaning contributions lower your taxable income, which may help lower your income-tax liability in the current year. For those under 50, the 2019 annual 401(k) contribution is $19,000, but for those over 50, an additional "catch-up" contribution of $6,000 is allowed, or $25,000 total.
Beyond the tax-deductible contribution, the second advantage of a 401(k) is tax-free growth. Once contributed, money in a 401(k) is generally locked up till age 59 1/2, but all the earnings on your contribution grow tax-free until withdrawn. Withdrawals are considered ordinary income and fully taxable. There may be penalties to take your money out of a 401(k) prior to age 59 1/2, though some exclusions apply, so it's important to have an emergency fund set up. For more on how to make the most of a 401(k), Motley Fool's Our Guide to 401(k)s for Beginners is a good start.
4. High-interest debt
If you've gotten this far -- saved up an emergency fund and contributed to an HSA and 401(k) up to the match -- then it's time to pay down high-interest debt. JPMorgan Chase recommends making additional principal payments on higher-interest loans, such as credit card debt and student loan debt, as a fourth priority. A high interest rate is considered to be greater than 6%. If the rate is lower than this, such as, say, a 4% mortgage, then JPMorgan Chase thinks you are better off investing in a diversified portfolio because you can hopefully earn more on your money in the stock and bond markets over time to outweigh your interest owed.
To clarify, the study suggests making additional principal payments "on loans with a higher interest rate than your long-term expected investment return." In other words, if you think you can beat the 4% hurdle rate on your mortgage in a diversified investment portfolio, then that may be a better use of your money than making additional principal payments. However, if the loan rate is higher, say 6% or 7%, then it gets a little tougher to beat in a diversified investment portfolio, and more priority should be given to paying down the higher-interest debt than investing. If there is no higher-interest debt, then priority is given to additional contributions to the health savings account and 401(k) after the match.
All in all, when it comes to where to save your money, consider these top four places first. From building an adequate emergency fund, to funding accounts that offer a match like the HSA and 401(k) to paying down high-interest debt, building priorities helps ensure you're getting the most out of an annual savings plan. To view the full report, including the five next most important places to save your money, see JPMorgan Chase's 2019 Retirement Guide.