Welcome to the Brewing FIRE Investing Hierarchy. In this post, I will lay out the hierarchy of saving that my family follows each year as we continue on our path to financial independence. Although everyone’s situation is unique, this guide should be applicable to most people who are determining the best way to invest their money. You may not have access to all of these accounts, but the hierarchy includes most investment options. The ordering of the hierarchy is primarily driven by tax efficiency.
It is important to prioritize your savings buckets according to their relative benefit. The benefit of each investment vehicle is directly related to the tax savings, or ‘instant return’, of each option you have. This helps determine the order in which you should invest and max out your respective accounts.
Below the Investing Hierarchy, I’ve included a chart that shows you the Instant Return for each investment. The Instant Return represents the savings/debt reduction/company contribution that is immediately realized by making the investment. Of course, any actual returns will go above and beyond this value.
Disclaimer! I am not a tax professional, investment advisor, financial planner, or your smart, successful uncle. If you have questions about anything in this post, you should seek the advice of someone other than me.
The Brewing Fire Investing Hierarchy
- Emergency Fund / Savings
- 401k up to Company Match
- Debt >6%
- FSA (only what you’ll use)
- Max out 457
- Max out 401k / 403b
- After-Tax 401k
- Taxable brokerage account
In the below descriptions, I will cite the effective marginal tax rate, or EMTR, as part of the calculations. This is essentially the portion of your gross income that goes to all taxes (payroll, federal, state, property) each year. 20-25% EMTR is normal for the average American household; the Brewing FIRE household had a 20% EMTR last year.
Edit: I’ve also added brief descriptions of each type of investing bucket I reference, for the sake of people who don’t have to deal with the convoluted US tax code. Unfortunately, any calculations for Instant Return or tax savings will only apply to Americans.
1. Emergency Fund / Savings
Before you begin filling your investment buckets, it is wise to build an emergency fund. How big should it be? Most people suggest 3-6 months worth of expenses. I think this is sufficient, and the Brewing FIRE family normally has ~5-6 months expenses in savings.
2. 401k, up to Maximum Company Match
The 401k is an employer-offered retirement plan that offers the advantage of tax-free contributions. This is free money! As soon as you’ve saved enough to cover your basic needs, you should start contributing to get the match. Instant return is 100% on this investment.
3. Debt > 6%
Pay that shit down!
There is an ongoing debate on whether it is better to use available cash to pay down debt, or to invest. This revolves around expected returns. The (negative) return on your debt is the interest rate, or [interest rate * (1- EMTR %)] if you can deduct interest paid. The long-term rate of return on the S+P is approximately 10%, or 7% when adjusted for inflation. Therefore, if the interest on your debt exceeds your expected return rate, you should pay it off. Start with higher-interest loans first, and take advantage of the snowball effect.
4. HSA – The Triple Threat
The HSA (Health Savings Account) and FSA (Flexible Spending Account) employer-sponsored savings accounts that allow you to pay for health expenses with pre-tax dollars. This post by the Mad Fientist will tell you everything you need to know about the advantages of using an HSA. HSA’s represent the “Triple Threat,” since you can make pre-tax contributions, the money grows tax free, and distributions (withdrawals) are tax free, as long as they’re used to reimburse for qualified medical expenses. This really is the best account you can have.
5. FSA, Up to the Amount You’ll Use
If you know you’ll have qualified medical expenses, including dependent care expenses, you should fund your FSA up to the amount you will need. This way, you’ll be paying with pre-tax dollars for these necessities.
6. Max Out 457
A 457 is a pre-tax retirement plan that may be offered by some governmental (and certain non-governmental) employers. The advantage of a 457 plan over a 401k or 403b is that you can make penalty-free withdrawals any time after leaving your employer. The withdrawals are still taxes as ordinary income, however.
7. Max Out 401k / 403b
The 401k and 403b are also employer-sponsored, tax-advantaged retirement plans. Similar to the 457 situation, except early withdrawals from these accounts are subject to a 10% early withdrawal penalty. Instant return = [1/(1-EMTR%)-1], ie. if your marginal tax rate is 20%, you will realize an instant return of 25%.
8. Employee Stock Purchase Plan (ESPP)
If you work for a publicly traded corporation, and your employer offers you an Employee Stock Purchase Plan (ESPP), then you should be taking advantage of this opportunity in almost all cases. You should think of the ESPP as part of your compensation; you’re leaving money on the table if you don’t use it. I will cover the reasons for participating in your company’s ESPP in a dedicated post.
IRAs, or Individual Retirement Accounts, are tax-advantaged retirement accounts that are not affiliated with an employer and are available to anyone. Often times, employer-sponsored accounts such as 401k’s can be rolled over into an IRA as part of a retirement or draw down strategy. Next, fund an IRA. Again, the Mad Fientist has an excellent summary of the choice between Traditional (pre-tax) and Roth (post-tax) funding options. Here’s the bottom line: if you can deduct your contributions, use the traditional IRA option. If you can’t deduct, go the Roth route. If you earn too much to make Roth contributions, then it’s the Mega Backdoor Roth for you!
10. After-Tax 401k
Speaking of the Mega Backdoor Roth. If your employer gives you the option to invest after-tax money into your 401k (beyond your pre-tax contributions), and especially if you can make in-service distributions, then you should do it. The reason is that you can convert your money to a Roth account, which protects your gains/distributions from taxes in the future.
11. 529 College Savings Plan
529s are College Savings Plans that offer tax-free growth and tax-free distributions for qualified higher education expenses. Additionally, some states offer a state income tax deduction on contributions. Think about funding a 529 plan if the following applies to you:
- You have kids
- You like your kids
- You’d like to help defray some of their higher education expenses
- Your state lets you deduct contributions from the state portion of your tax return
Check out this site for more information on the 529 plans offered in your state.
12. Taxable Brokerage
Finally, we arrive at the taxable brokerage account. This is at the bottom of the investing hierarchy because there are no tax advantages here. You fund with after-tax money, and pay taxes on (realized) gains and dividends.
An alternative to funding your brokerage account with any additional money is to pay down your mortgage (or other low-interest loans). This comes down to your personal situation, as there is not a significant advantage to paying down low-interest debt, especially when the expected returns from another investment would presumably outperform the return of reducing your debt. Here’s a nice discussion on the topic from the Rockstar Finance archives. Additionally, the new tax law means that more households will be taking the standard deduction, and thus the ability to deduct mortgage interest is no longer advantageous.
One advantage to paying off your mortgage is that it can significantly reduce your monthly expenses. For this reason, the Brewing FIRE family is trying to concurrently pay off our mortgage as we also contribute to investing buckets #1-12. Stay tuned for more details on this experiment in the future.
Instant Return of the Investing Hierarchy
The following table represents the Instant Return for each of the investments listed above. Again, the instant return is the gain you immediately realize through either tax savings, debt reduction, or a company match (based on a 20% effective marginal tax rate). In addition to the instant return, you can also expect capital returns, growth, and/or dividends from your investments, depending on the particular details of the investment. I am only detailing the instant gain from choosing to invest.
Again, your situation might be slightly different from mine, especially if you’re in a significantly different tax bracket. But if your income is somewhere around the average for an American household, then the investing hierarchy I’ve laid out should work pretty well for you.
What do you think? If you agree, disagree, or see any issues with my plan, please comment below!