Nick H recently emailed me a question about how much money he should invest in tax-advantaged accounts before adding to non-qualified accounts. Due to the large number of emails I receive I am unable to provide individualized tax advice unless you are a client. Nick’s question had a familiar ring. Several times per week I get a variation of the same question. Rather than ignore the request, I decided to put it into a post so all readers can benefit from my suggestions.

Here is Nick’s complete email:

Dear Wealth Accountant,

I have been a reader of yours for a few months now, and enjoy it very much.  I was introduced to your site via a MMM post.

I have a question for you regarding investing in tax-advantaged accounts vs. normal accounts. Standard advice is that I should max out tax advantaged accounts before saving in normal accounts.  However, with financial independence/early retirement in mind, if I do not make enough to max out tax advantaged accounts and save enough in a normal account for early retirement, I think that it makes more sense to put just enough into a 401k to get my match, then save everything else I can in a normal investment account.

I reach this conclusion because the goal of early retirement is to build up an income stream, unlike standard retirement in which you just achieve the largest possible pile of cash.  Since there are significant limitations on access to the funds in taxed advantaged accounts, this seems like an inefficient method of saving.  Again, assuming that I have to choose between the two.

-Nick H

PS. I also posed this question to MMM.  I am very curious to get both of your perspectives on it.  Thanks & hope to hear from you!

Nick makes a narrow assumption of either/or. He indicates he either has to max out his retirement accounts before funding non-qualified accounts or he will not have an income stream to fund his early retirement.

Nick also turns the tables on the standard advice by saying standard advice says to max out retirement accounts. I guess it depends on whose standard advice we are looking at. Most standard advice is geared toward generating larger fees for the investment house. Standard advice says you should save 10% of your income. It makes me nauseous thinking about it.

Filling the Kettle

From the email it seems to me Nick wants me to justify his conclusions. I cannot. Investing in a work 401(k) up to the matching level only because it is hard to get the money out in early retirement is narrow thinking.

My opinion, and the opinion of most bloggers in the FIRE (financial independence, retire early) community, teaches you should invest as much as possible in tax-advantaged accounts before filling non-qualified accounts. My standard advice is to save half your gross income. Money invested in your 401(k) is tax deferred. Each dollar invested in a qualified account that is deductible reduces your taxes making it easier to save more.

If you are saving 50% of your gross income the 401(k) will not be your only saving/investing vehicle. You will probably use a Roth IRA in combination with your 401(k). The beauty of a Roth IRA is you can take your basis out at any age without affecting your taxes.

Early retirement requires distribution planning. Once you retire you will probably transfer your 401(k)/457 plan/403(b) or other retirement plan from work to a traditional IRA where you can take distributions under Section 72(t) or 72(q) if you have an annuity. There is a wide range of options available when beginning distributions from an IRA. The biggest issue involves how long you MUST keep taking distributions if you retire early. The rule is simple: once you start distributions under 72(t) you must continue until age 59 ½ or five years, whichever is longer. The distribution amount is generally fixed, but can go up in certain instances for inflation.

Distributions are calculated by one of three methods: Minimum Distributions Method, Amortization Method, or Annuitization Method. So we can stay focused on the topic at hand—how much should go into a retirement account before other accounts—we will avoid a lengthy discussion on the different methods. Each method does yield a different result. For example: a 40 year old with $750,000 in his IRA can take an annual distribution of $17,202 to as high as $27,729 assuming her spouse is the beneficiary, also 40 years old, with a hypothetical before-tax return on the investment of 6% and a distribution interest rate of 2.36%.

The $27,729 distribution brings us very close to the 4% rule rate of $30,000. But if you have been saving half your gross income, the 401(k) was not the only act in town. You should have some Roth IRA investments too. Maybe your income was too high so you used a backdoor Roth or made nondeductible traditional IRA contributions. A small side hustle would be more than enough with the 72(t) distribution to cover living expenses.

Even if 90% of your liquid investments were inside qualified accounts, you would still have non-qualified monies to meet additional expenses not covered by the 72(t) distribution. The higher distribution amount, $27,729, uses the amortization method of calculating the distribution amount. Under this method the distribution must remain unchanged. As time goes on the amount will be reduced by inflation. However, any Roth investments and non-qualified accounts can handle the small increase needed each year. And, since you will not retire with a remote in one hand and a beer in the other, you will certainly bring in token amounts of income just doing stuff you enjoy doing.

Problems with Regular Accounts

Non-qualified accounts have their own set of issues. If we follow Nick’s suggestion we will have a growing problem which will delay retirement. Money inside a retirement account grows tax deferred or even tax free. Index funds (the only thing we recommend around here) in a regular account will throw off ever increasing amounts of dividends and capital gains. Index funds generally are tax efficient, but as dividends grow each year, you will have a larger and larger tax burden to fund. Money paid in taxes reduces the funds available to invest, decreasing the size of your portfolio, hence, delaying early retirement plans.

Another issue with non-qualified accounts is that you will need a larger portfolio in retirement. Remember, once you retire, the index fund distributions are taxable whether you take them out or reinvest. Depending on your financial situation, this could increase your annual cash needs to fund retirement. If the dividend and capital gains distributions remain below your spending level the tax issue is moot. However, if you reinvest some of the index fund distribution you will have a higher tax bill than necessary, requiring more money to manage your annual financial needs.

Tax Loss Harvesting

There are ways to mitigate some of the tax issues surrounding investments with non qualified monies. Tax loss harvesting with programs from companies like Betterment should reduce taxes modestly early on. I like the idea of tax loss harvesting, but it is an imperfect solution to a problem. I recommend Betterment often enough and I am not an affiliate either.

GoCurryCracker! has a great article on why Betterment is not always the right answer. The maximum loss allowed after all other capital gains have been reduced is $3,000 per year. Yes, this deduction is against ordinary income and comes off your highest tax rate. Yes, when you later have a long-term capital gain it is taxed at LTCG rates which are lower.

There are serious considerations when using Betterment, as the GoCurryCracker! article makes clear. As much as I recommend tax loss harvesting, I also recommend tax gain harvesting! When your income is low it pays to realize LTCGs and pay the tax to get a higher basis. Many times your tax is zero on the gain when you plan accordingly!

The more money you have in regular accounts, the harder it is to manage the tax issues. Several million in non-qualified accounts will throw off significant amounts of taxable dividends and capital gains. Inside a qualified account you can keep deferring the money without tax consequences for a long time.

Roth IRAs have a delayed required distribution rules.* Traditional IRAs require a distribution once you reach 70 ½.

Investing Order

I have a list of the order you should invest your money. It starts with paying off debt and moves to investing in various accounts and assets. Your circumstances may require you to deviate slightly from my outline.

  1. Retirement plan at work up to the matching level.
  2. Debt reduction.
    1. High interest loans first
    2. Credit cards, payday loans
    3. Car loan
    4. Student loans
    5. Only pay required mortgage payment
  3. Non-qualified account for emergency needs (roof, car issues, medical, et cetera). Two months living expenses
  4. Health Savings Account (I might want to fill this first due to the significant tax advantages.)
  5. Max out retirement plan at work.
  6. Max out Roth IRA and any other qualified accounts outside work plan.
  7. Any additional fund go half to paying down mortgage faster and half to non-qualified accounts invested in index funds. Emergency fund no longer needed as you have ample funds to handle any emergency.
  8. Alternative investments
    1. Investment properties
      1. Residential rental real estate
      2. Commercial real estate
      3. Farmland
      4. Development
      5. Lending Club
      6. Other alternative investments.

Filing your taxes with this link supports this blog. Thank you.

The above list is similar to the way I handle my investment order. Since my only debt is my farm and the interest rate is under 2 ½%, I am in no rush to pay the mortgage off. I max out all retirement plans and the HSA before investing in non-qualified accounts. In reality, I invest in my non-qualified each month automatically. I do know all other qualified accounts will be fully funded.

I am not a big fan of emergency funds, but if you are starting out they can provide a buffer against financial setbacks. Alternative investments like Lending Club are passive is nature. Real estate is called passive for tax purposes, but requires more involvement in the investment than most other passive sources of income, even if you have a property manager.

And stay away from the crazy stuff. You can’t time the market any better than any other human to have ever lived. No day trading! Avoid commodities (unless you are hedging for your business or farm) and currencies. This includes Bitcoin.

I know, I know! Your uncle Fred made a killing in soybean futures and Bitcoin and you want in on some of that easy money. But remember, your uncle Fred is 78 and still can’t retire. Tells you something.


* Roth IRAs can delay required distributions for a long time. Under current law Roth IRAs do not require distribution until the death of the owner.