Invest Simply And Wisely Using A Waterfall Of Tax-Efficient Accounts

Our overriding investment philosophy at Aptus is “keep it simple.” As we highlight in our Hierarchy of Financial Needs, your retirement outcome is more likely to be determined by your savings rate than it is to be driven by clever stock picking or crafty asset allocation decisions.

The first step in investing, then, is to determine how much you can save. We recommend adopting and implementing a cash flow system to help sharpen up your savings calculations. A good cash flow plan should help you determine the best balance of spending on important things like education and travel while saving enough for an emergency fund, paying off debt and building up a retirement nest egg. We recommend saving 10%-40% of gross pay into retirement accounts, depending on your age, income and goals.

The next step in investing is determining how best to utilize the various retirement accounts available to you. We recommend following a tax efficient waterfall, filling up each bucket before moving to the next level down. The precise waterfall will vary based on your specific circumstances, but there are some general rules of thumb.


 We start the waterfall by making sure you claim any free money from any matching contributions in employer retirement plans. Then we recommend paying down high interest debt, like credit cards, to get an attractive, guaranteed return that positively impacts your net worth. 

For folks with high deductible health plans, which are increasingly common, a health savings account (HSA) has triple-tax benefits that makes it a great long-term retirement account—contributions to an HSA are tax deductible on the front end, investment income is tax deferred as it grows, and withdrawals are tax deductible if used for health expenses. And who doesn’t have high health expenses in retirement? If you use an HSA for retirement savings, make sure to set aside money for your near-term healthcare costs.

Next, we typically recommend maxing out our pre-tax contributions to qualified retirement plans. Younger people may want to consider the Roth 401(k) option if available, but most people will want to avoid taxes now. 

For tax diversification—to balance out your eventual retirement plan withdrawals that will be taxed as ordinary income—we would then look to contribute to Roth IRAs, either directly if under the income limits (of ~$193,000-$203,000 in adjusted gross income for married tax filers in 2019) or through the “backdoor” if over those limits. In a backdoor Roth you contribute to a non-deductible traditional IRA then, typically the next day, convert it to a Roth.

Finally, we move on to investing in a taxable brokerage account. We recommend tax-efficient index funds that don’t generate significant capital gains so you are generally only paying taxes on bond income and stock dividends, often at favorable rates. You can also consider paying down lower interest debt.

The last, and probably the easiest, step in investing is buying an appropriate mix of assets. We encourage our clients to capture broad market returns across a range of asset classes utilizing low-fee index funds. Especially for younger investors, we principally focus on stocks and bonds. Older and higher net worth investors might use sub-classes of stocks and bonds—like inflation-protected bonds—and/or alternative investment vehicles like real estate.

We believe that low-fee, target retirement index funds are a great option for most individual investors. Target retirement date funds from Vanguard, for example, include an age-appropriate, diverse mix of U.S. stocks, international stocks, U.S. bonds and international bonds. The funds continually rebalance to maintain a suitable asset mix and automatically adjust the mix over time to become less risky as you near retirement age. Target retirement date funds allow you to “set it and forget it,” so that you can focus on your day job.

For those that need or desire more control over their investments, our asset allocation recommendations are primarily informed by the averages of a host of target-date fund families. These funds incorporate the collective wisdom of investment strategists from the biggest mutual fund companies in the world, including Fidelity, JPMorgan, T. Rowe, Vanguard, American Funds and TIAA-CREF. We consider the averages of these target-date funds as our best estimate of risk-neutral, age-appropriate allocations. We are not trying to make bets.  

These average allocations are only a starting point for individual investors, albeit one that often reflects the right course for most people. There are several factors that might impact risk/return trade-offs and allocation decision. While age and time horizon are important factors, an individual’s current or expected level of wealth—relative to their spending levels—is another critical factor in determining asset allocation. Increased wealth enables an investor to take a longer-term view, perhaps even multi-generational, and accept higher risk. We also consider an individual’s risk psychology. While we encourage a dispassionate approach to investing, it may not be wise for someone to invest primarily in stocks if they know they will panic-sell on market dips. 

As DIY sherpas, we believe we can coach our clients to avoid those instinctual moments of panic. If you save appropriately and invest simply and wisely, you will eventually reach the retirement summit. You can do it yourself, but you don't have to do it alone.

Tim Quillin