In the past several posts, several different ways to save were outlined showing how and why automated plans should be taken advantage of. Current tax savings, matching contributions, compounded tax deferred or even tax free growth, and potential tax free withdrawals (if using Roth or HSAs) are all terrific motivators to get started.
So, how would I direct my savings if I were accumulating assets now? What would be my strategy? Importantly, let’s first recognize that most folks find it extremely difficult to fund each type of account to their annual limits. That’s a lot of extra money to have floating around. If you’re like most and have limited discretionary income to save, how is the best way to save with them? Well, it depends on what you have available to you.
But, before going into any type of hierarchy, let’s be sure the basics are taken care before heading down this road. Make sure you have 3 to 6 months of living expenses tucked away in a bank savings, money market or other liquid account. The point of this reserve is not to grow the account or make money but rather have that buffer to help you in the event something unexpected happens. And let face it, life sometimes gets in the way of our plans. The emergency fund insures that you don’t have to liquidate your investment accounts when you’ve lost your job and the market is down at the same time.
You can certainly determine what makes up your 6 months of expenses, but to get you going, what I have used as baseline in the past is adding everything up that is a necessity and a recurring expense. You can go with this as well. Think about what you pay or purchase every month that you must have. Mortgage/Rent, property taxes, property/car/life insurance, food, utilities (electricity, water, gas/oil), car payment, cell phone, internet, medical insurance, etc. Also remember to take into account that medical coverage may be much more expensive if you need to use your former employer’s COBRA option to bridge you until your next job. Dining out, gym memberships, entertainment and the like can all be put on hold for awhile until the emergency has passed.
With the emergency savings safely set aside, what would be a logical way to take advantage of various savings plans available to you? Let’s go through it:
A. Employer 401(k) or 403(b) – with an employer’s match. This creates not only a current year tax deduction but most importantly free money (the match). If your employer is matching your contribution 100% up to 5% of your pay, then that’s 5% raise going towards your future. You’ve got to take advantage of it. If you have extra money to save once you invest up to your employer’s match, move onto Step B.
B. Health Savings Account (HSA) – often employers incent your participation by matching or depositing an employer contribution. If they do, this is a terrific way to jump start the account. Remember, HSAs offer triple tax savings: Your contributions are tax deductible, balances grow tax deferred, and withdrawals are tax free if used for medical expenses (plus you save on FICA deductions of 7.65% on your contributions).
C. Savers Choice – if still you have money left over at the end of the month then there are a couple of directions you can go:
- Traditional IRA or Pre-tax 401(k) – either of these are fine to add to if you are looking for additional current year tax deductions. The advantage of the Traditional IRA is you have more investment options available, however there may be some fees or commissions to pay. If your 401(k) has excellent investment options, or better yet, a brokerage account option and the fees are reasonable, the 401(k) can work. The additional benefit is will consolidate the number of different types of accounts you have.
- Roth IRA or Roth 401(k) – If you don’t need the current year tax deduction, or alternatively, value tax free withdrawals in retirement, Roth accounts are great options to add to your retirement portfolio for tax diversification. Same logic applies as to which account you decide to fund based on your employer’s plan options and charges.
- Brokerage/Investment Account – This is a good direction to go to build up accounts that can bridge your cash flow needs between the time you retire early and age 59 ½.
If I could go back in time and re-do some of our savings, knowing what I do now, I would beef up my brokerage account. Our focus for the majority of our savings life cycle had been tax advantaged accounts. Creating larger regular investment accounts could have potentially allowed an even earlier retirement.
Our accounts are basically ⅓ brokerage/investment accounts and ⅔ tax advantaged accounts with the vast majority in tax deferred accounts. While we were saving, the tax deduction was very seductive and we tried to maximize it each year to lower our tax liability. We also didn’t have access to an HSA until 5 years ago. Having that option earlier in our careers would have been the best option to fund as quickly as possible. Spreading your savings across the three different types of accounts based on the tax treatment provides you more options to minimize taxes in the future.
I would recommend, if the savings options are available to you, to save using Step A, then Step B, and then split C(2) and C(3). This maximizes any free money provided to you by your employer, provides a current year tax deduction, and creates tax diversified accounts.
How about you? What order are you saving toward the future?
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