Tax-Advantaged versus Regular Accounts

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.

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.

Keith Taxguy, EA

Keith started his tax practice in 1982 and went full-time in 1989. An enrolled agent (licensed tax professional) since 1992, Keith has focuses on helping businesses and individuals pay the least amount of tax allowed by law.


  1. John on January 30, 2017 at 9:34 am

    Keith, quick question I struggle with. I have about 15k in student loans and about 5k left on a car loan both at 2.5% interest. Very cheap. My 401k is at 10% of my salary, above the 6% match. Part of me wants to pay off the loans early and only go up to the matching max, since the market is so expensive. Would you mind giving me your opinion? Once again, I love the site. I’m a CPA who does forensics and I have learned a tremendous amount.

    • Keith Schroeder on January 30, 2017 at 6:57 pm

      You are already saving 10% plus the company match. Personally I would put a shoulder into the auto and student loan. Which one to pay off first is up to you. Student loans are like acid so I always recommend retiring them first. But the auto loan is small and it would be nice to dump at least one loan fast. Once the loans are done I would max out the 401k followed with maxing out any IRA possibilities. Then the ‘ol non-qualified account can get some recognition.

      Then again, since the rates are so low, I might increase savings/investing equally with loan retirement. When someone is responsible with money I am more open to encouraging additional investments while paying off the loans a bit slower. Notice I don’t mention the deduction for student loan interest. It is a tax benefit, but not a reason to keep a loan longer than necessary to accomplish the goal.

      Finally, the market is always expensive. Massive bear markets look like a speck of fly shit after a decade or so goes by. The value of businesses keep marching higher decade after decade. The risk is being out rather than being in. I dump money in the market each month and when I have excess I haven’t invested I dump that in too. I don’t pay much attention to the Dow averages. Over a decade or more it will be higher.

      • John on January 30, 2017 at 7:19 pm

        Thanks for solidifying my belief. I’m more analytical than emotional when it comes to investing/debt. However, there is something to say about paying off a car loan and regaining that cashflow while being less leveraged. I will tackle that first and then move on to paying the student loan in chunks.

        Good point on the market. I know it’s silly but If it was tanking now I might change my mind and increase my 401k investing. I just feel that at some point in the next two years there will be a solid correction so perhaps its a better time to use tackle my low interest debt as opposed to investing that extra $. If these loans were at 6% then I wouldn’t even be debating it.

  2. Chris on January 30, 2017 at 4:06 pm

    HI Keith, love the site but I have follow up questions on this one. I feel like usually people recommend the emergency fund first. Could you elaborate more why you’re not a fan? With regards to paying off car/student loans before retirement accounts, I rank them much lower. If you don’t pay off your house, make your student loan payment, and lose your job and they still take the house. If you pay off the house and then lose your job, the student loan can be deferred/at least you have a place to live. Also, not putting money into a tax deferred account has a cost in terms of the missed opportunity. Once the fiscal year is over a backdoor Roth contribution for that year goes away forever. I’d rather borrow at a prime car loan rate and take advantage of the opportunity to have an extra $5,500 growing tax free for the rest of my life. Do you think whole life insurance has a place on the list as well? Obviously assuming you need life insurance anyways. The tax advantages of a whole life cash value policy make it much more attractive relative to paying off most mortgages. For me this falls between #’s 6 & 7. I also think several alternative investment strategies could frequently come above paying down your house depending on they’re return potential. A home mortgage is a cheap, tax deductible source of capital, which means it often makes more sense to keep it in favor of having debt tied to investments such as rental properties or farmland. I am a CFA charter holder next door in Minnesota with a 75% savings rate and am looking forward to early retirement in about 5 years.

    • Keith Schroeder on January 30, 2017 at 6:45 pm

      Chris, can you imagine telling Bill Gates he needed an emergency fund? I never had an emergency fund. Emergency funds might have value to the very poorest people who never saved a dime in their life (and Dave Ramsey fans). But for the rest of us we can come up with a few dollars to handle a flat tire or other minor inconvenience.

      As for loans: my attitude toward borrowed money is to use it as a short-term tool only. I am not afraid to borrow if it bridges a short-term need without selling an investment or to smooth finances. I haven’t borrowed for a personal need in forever, but in the business I use borrowed money to smooth cash flow periodically. Student loans bother me the most because they are hard to discharge in bankruptcy and can even affect your Social Security check. The best student loan is one you don’t have.

      Keep in mind, I made it clear in the text you might modify my order to reflect your personal situation.

      Term life is the only thing I would consider. Cash value life insurance is for the mathematically challenged. You can disagree, but I am right on this one.

      As an accountant I see how badly most investors in alternative investments fare. Alternative investments should only be a small fraction of your liquid net worth. The greatest pain usually follows getting cute with your investments. Remember how value is created: return on invested capital – cost of capital. ROIC above COC is the textbook definition of value creation. Too many alternative investments forget this most basic of rules.

      • Chris on February 1, 2017 at 3:10 pm

        Thanks for the reply. I’d also be interested to hear your thoughts/opinions on if/where 529 plans belong on the list.

        • Keith Schroeder on February 1, 2017 at 3:17 pm

          Ooooo! Good one, Chris. Between 6 & 7. The basis in a Roth can be used for ed expenses too. Education accounts come after retirement. It’s like an airplane: Take care of your mask before helping the kids; you can’t help the kiddos if you are unconscious. Also, youngster need to take some responsibility for their education by getting scholarships.

  3. Paul on January 30, 2017 at 7:46 pm

    Hi Keith. For those without a home yet, what are your thoughts on saving for a down payment vs maxing 401k’s and IRA’s? If my Wife and I max out both retirement accounts, that would extend the time it takes to save a down payment . Considering we would prefer to put 20% minimum, but more if possible, that could make it a long time before we save that up. I understand everyones circumstances differ, but if you have any thoughts in general it would be appreciated.

    • Keith Schroeder on January 30, 2017 at 7:52 pm

      Saving for a home is different. I agree with the 20% down minimum. Saving a large percentage of income does not mean it automatically goes to retirement accounts. I would at the very minimum contribute to your 401(k) up to the match limit. Then I would roll up the sleeves and get that down payment fund growing.

      I have another suggestion. If you are able to make Roth IRA contributions I would max those out too. You can use the basis for the down payment and leave the profits ride. Just a thought.

  4. Jonathan Mendonsa on January 31, 2017 at 6:29 am

    Keith, this is the article I have been waiting for someone to write. Fantastic information!

  5. Viktoria on January 31, 2017 at 7:13 am

    Keith, thank you for another great article, always such a treat to read your thoughts. A question about step #7: you recommend splitting extra funds 50:50 between one’s mortgage and other non-qualified accounts. However, right below you state that you are in “no rush” to pay your mortgage off which I read as “don’t pay it off sooner than necessary”. So should one prepay cheap mortgage (say <3%) rather than invest, and why?

    • Keith Schroeder on January 31, 2017 at 8:03 am

      Viktoria, the list is a guideline, not a hard and fast rule. The 50/50 rule needs modification depending on interest rates and personal preference. I don’t pay my mortgage off in full, but I still dump extra in each year even though the rate is so low. I just want to eliminate my last loan regardless of the interest rate. Also, you can always sell the non-qualified account to pay off the mortgage, but the investment could be down in value. What I will do? I will pay off the last $110k of my mortgage in the next 12-18 months. I know just about any investment will return more than the mortgage rate. That isn’t why I’ll pay it off. The reason is I don’t want to have any debt service payments.

      Also, I tell clients endlessly that paying off the mortgage has wonderful side effects. 1.) It takes 10 years off. Think about that ladies. Ten years off the top without seeing a doctor or makeup. Same for you guys. 2.) Nobody ever lost their house to the bank without a mortgage. Sounds stupid, but it needs saying. What if things did get really bad? Without a mortgage or any other debt you can survive almost anything financially. You can cut any expense in your life except debt servicing. That stuff sticks like packing grease.

  6. Jerry Gordon on February 1, 2017 at 5:08 pm

    Keith Thanks for the article..Great question to you is I am currently a teacher so there is no way I could max out my 403b and an IRA. You say to max out the 401k (403 for me) and then max out the IRA. What difference does it make which one you max out first?

    • Keith Schroeder on February 1, 2017 at 8:26 pm

      Mostly matching. Once you no longer get a match you can invest in an IRA before finishing off the 403(b). It is too long to discuss all the possibilities, but an IRA is an adjustment to income and a retirement plan deduction on the W-2 paycheck lowers total income. In rare cases it could make a difference.

      A self-directed IRA also has more options than a retirement plan at work. Something to consider. It also could make a difference.

  7. Michelle on February 2, 2017 at 1:56 pm

    If we are able to max out both my 401K and my husbands and then put funds into a Roth IRA and then non-qualified accounts, what is the best way to take advantage of the 401K when it offers both a traditional and Roth option? I have been splitting the funds but as income levels grow, is it better to put more in the traditional 401K rather than the Roth option?

    • Keith Schroeder on February 3, 2017 at 4:17 pm

      Best way is a subjective term, Michelle. Your tax bracket will determine if more retirement plan deductions help or if future tax-free income from a Roth is better. I like splitting the investment between Roth and traditional. However, if your tax bracket is up there, you might want to focus on more funds in the traditional (deductible) end.

  8. Mary on April 30, 2017 at 3:27 am

    I have not noticed anyone on the interwebs’ FI bandwagon dealing with THE big problem of tax-advantaged accounts, which is the fact that the money is trapped by government fiat. That $20ish trillion is too temping for a bankrupt, decaying empire that is in debt roughly the same amount. It is certainly possible, if not probably, that one day in the not too distant future, when the next financial crisis hits, politicians will look to stealth confiscation of private retirement accounts to bail the system out. This has already happened in other countries. Having funds outside of those sitting duck retirement accounts might be all that is salvaged.

    On another note, I can’t understand an accountant recommending that people pay down their mortgages, especially now with historically low interest rates. Seems to me the majority of w2 earners have no deduction left other than for their mortgages. And they certainly have no other inflation protection. I keep reading FI types recommending paying down mortgages, and I’m not surprised since many of them are painfully inexperienced, but an accountant? REALLY???

    • Keith Schroeder on April 30, 2017 at 7:20 am

      Your timing, Mary, is remarkable. Several FI bloggers and I are in a private meeting this weekend and the discussion turned to the first topic you mention: will tax-advantaged accounts get nixed, taxes, confiscated, et cetera in the future? The short answer is yes, the longer, and more honest answer, is more complicated. My personal opinion is that Social Security will eventually be needs tested. In this scenario, savers will get a lower, or no, Social Security check until their net worth drops below a certain level. Another option is to tax all of Social Security benefits instead of exempting some of the income from taxation. Time will satiate our curiosity.

      I think you misunderstand my position with mortgages. Debt is only an issue when handled poorly. I will personally pay my mortgage off over the next twelve months. This is a personal choice, not an optimal financial move. For me, I want to simplify my life as I focus on certain tasks I am currently interested in. As for the mortgage deduction, it’s a farce. You are welcome to disagree, but where does giving the bank $10,000 in interest just so the IRS lets you deduct the expense and get maybe get $3,000 back on the tax return become a good deal? If you want the deduction so bad you can donate the money to charity and get the same deduction. Better yet (for me), tax preparation fees are also deductible (to an extent). I also recommend if you want a large deduction, you pay your tax pro more. Might I recommend me! For some reason clients never want to pay me more even though they can deduct it. At the end, Mary, the mortgage deduction is a modest help for homeowners. Don’t get hung up on the deduction; it’s not that big a deal. Worse, tax law changes could take it away and you’d still be stuck with the mortgage. However, best of all, if you have no mortgage you pay the bank nothing and still get the Standard Deduction, a faux double-dip.

  9. Scott on November 8, 2017 at 4:47 pm

    Great article! The hierarchy is a great guide!

    The thing I struggle with the most is where to put your money if you’ve been saving mostly in a 401k for 20+ years. When you look at your overall net worth and +80% is in your 401k, do you still continue to max it out if your goal is to retire early? I’m wonder if there is a rule of thumb or certain percentage of your liquid net worth you should have in Before Tax, Roth and Taxable by the time you retire early?

    • Keith Schroeder on November 8, 2017 at 5:10 pm

      There is no rule of thumb, Scott. Your personal situation will dictate your course. At a certain point traditional retirement accounts may not be the best choice. The balance between taxes, deferred taxes, tax on the current investment with tax-free distributions (Roth type plans) and nonqualified accounts is something you must choose. I’ve mixed and matched Roth and traditional retirement plans. I also have serious money outside retirement plans. I review my taxes and decide the best way to achieve my goals.

  10. […] Now we need to learn how to pick the best investment from a limited pool. The right choice in your 401(k) could shave years needed to retire and add tens of thousands of doll… […]

  11. Danny Gonzalez on January 19, 2019 at 8:05 pm

    Very interesting “order of operations” for investing order.

    One thing stood out. I’m curious when it comes to the HSA – why does that get such a high priority? I understand the tax advantages, but in many cases, I think it’s cheaper just to have a low deductible health plan. For example, at my job, I’ll compare the 2 plans, the only one that is HDHP, and the best one for me a Kaiser plan.

    The only HDHP plan qualifying for an HSA has a $0.00 dollar monthly payment. And a $3,000 deductible, and a $6,650 in-network out of pocket maximum for an individual (I’m a single guy, no kids). But for all care, the co-pay for a visit is 20% of the cost. Additionally, the HDHP plan is a co-insurance plan where I pay 20% of all costs up to the out of pocket maximum for the year.

    Kaiser Plan:
    This plan has a monthly cost of $70.40. It is a 0% / 100% coinsurance split up to the out of pocket maximum for the year, where I pay 0%. So the only thing I’m paying is co-pays on a per visit basis.

    A little arbitrary, but here I’m assuming every year will be like the past year. I had these medical events that I’ll assume will happen roughly every year in similar fashion. Events:
    – $100 Doctor’s Visit for Sick/Fever
    – $486.30 Orthopedist Visit – Knee Injury (or other injury I get messing around out there)
    – $550 MRI – at the request of Orthopedist
    – $ 486.30 Orthopedist – Review of MRI visit

    Total: $1,746.00

    On the HDHP plan with HSA – I pay the total $1746.00, because that’s below the $3,000 deductible. Adjusting down 24% to account for pre-tax funds used, I would’ve paid: $1,327.72 for the year.

    On my Kaiser plan, with only a monthly fee and 4 co-pays for 4 visits of $50/each, I would’ve paid: $1044.80 for the year.

    So, it seems to me, that I’m better off saving $282.92 – rather than paying for a more expensive health plan as a means of getting access to an HSA. Would anyone here disagree? And if so, why?

    • Keith Taxguy on January 19, 2019 at 10:25 pm

      I place the HSA high on the list because of the deduction and tax-free growth. Of course, you must have an HSA qualified plan for this to be an option. If HSA plans in your area don’t make sense then that option is out. Personally, I had an HSA for years because the numbers worked. Things changed and starting this year the HSA is out and I’m in a medical sharing plan. Facts and circumstances will prevail in the choice each individual takes, as always.

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