The Savings Avalanche
The third part of our S.M.A.R.T. InvestHER series is all about savings. I get asked about how and where to "invest" more often than any other question. Let me be clear here, savings goes hand in hand with investing. Many people don't like talking about "savings", but they really enjoy talking about "investing". Having a well-established savings strategy is pivotal to any investor. A savings strategy will help an investor save on taxes and potentially increase her portfolio yield. Let's take a look at how this strategy works.
First, separate your savings between taxable and non-taxable accounts. The asset allocation that you will use for investing your taxable accounts will look very different from your nontaxable accounts. For example, a taxable savings account that you will use for a down payment on a home in three years will be invested differently from a nontaxable retirement account that you won't tap into for 20+ years. The amount you can invest in a nontaxable account will depend on your income. Rules set forth by the IRS will prevent you from contributing to a deductible IRA or nondeductible Roth IRA, for instance, if your income exceeds the thresholds. This amount changes every year, so be sure to check the IRS website or your financial advisor or CPA for the exact amount. There are also restrictions on what types of investments can be in a non-taxable accounts and what investments are just not suitable for non-taxable or taxable accounts. Make sure you are looking at the rules and regulations.
Then I recommend what I call the "Savings Avalanche". We start small and then go big. This is a generalized order of recommendations, and remember that your individual situation might vary. Make an appointment with me if you want to talk about your specific circumstances.
Pre Tax Earnings
401k: Employer match
Health Savings Account
401k: Maximum contribution
Deductible contributions: Traditional IRA
Post Tax Earnings
5. Emergency Fund
6. Children Savings
7. Non-deductible contributions: Roth IRA
8. Taxable Savings
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401k Employer Match
You'll want to save up to what your employer will match. For example, if your employer matches 3% of your salary, you'll want to be sure you are also contributing at least 3% of your salary. This is not "free money", as some advisors like to say. This match is part of your compensation package from your employer! If your employer does not have a 401k, ask them what type of profit sharing plan or retirement package they do offer for employees. If you are a business owner, you'll have to evaluate other options like a SEP IRA or Simple IRA.
Once you save this amount of money, you'll want to make sure it's invested in a solid, long-term investments offered by your employer's 401k administrator. Look for options that are well-diversified, long-term investments. These could be in the form of mutual funds like "lifecycle" funds based on your age, or other well established funds.
2. Health Savings Account
This is a relatively "new" type of account, established in 2003. If your company offers an H.S.A., please do take advantage. You'll need to be enrolled in a high-deductible health care plan in order to participate, and double check the IRS contribution limits as they differ for families and single individuals. The idea here is that you contribute pre-tax dollars into this account that you can later use for qualified health expenses. Note that this is not the same as an F.S.A, a Flexible Spending Account, that has "use it or lose it dollars" every year. An H.S.A. will allow you to save the money for years and years and potentially even be passed down to your heirs after they pay your long-term care or funeral expenses. This is a great strategy to put into play with your portfolio. Check out other long-term investments to help you keep up with inflation and rising healthcare costs in this account.
3. 401k Maximum Contribution
Once you've maxed out #1 and 2, you'll go back to your 401k plan. Depending on your income, you'll want to max out the amount of money you save and invest in your account. For example, if you already received your 3% match, now you want to bump it up to potentially 13% of your salary, pre tax.
4. Deductible Contributions
Depending on your situation, you'll want to try and max out any and all pre-tax, qualified retirement accounts. Look for Traditional IRA, SEP IRA, Simple IRA, etc. Check out the IRS website as well to see if you qualify, or talk to a professional planner who looks at your entire financial picture. Once you contribute to those accounts, your investment selection process is next. Use your IPS as your guide and look for stable, well diversified, low cost investments that you are comfortable with for the long haul.
If you made it this far and still have money left over, congratulations! Now what should you be investing in? The next four items cover taxable accounts. Meaning, you've paid the IRS taxes owed on the income. Any future investments will be taxed on gains or additional income earned.
5. Emergency Fund
Before we get into the "fun" stuff, I want to be sure you have a well-established emergency fund. There's nothing worse than having your water heater or windshield break and need to replace it, other than using a high interest rate credit card to fund the emergency. Pre-pandemic, the old advice was to have 3-6 months' worth of expenses saved in case you were laid off. This is actual expenses, not including vacations, elaborate restaurant meals, or fancy clothes. I'm talking about what it costs to feed and care for you and your family. Post-pandemic, the advice has changed. Now I recommend that people have anywhere from 6-18 months of an emergency fund established. This is how long it may take you to find another job or start a business to take care of your family, if needed. Find out what your number is, and invest it in securities that can easily turn to cash if something happens, and won't be so volatile or high risk.
6. Children's Savings
This is an optional step, but one that I highly recommend you look at if you have children, grandchildren, nieces or nephews or minors of any kind that you feel a responsible obligation. College is expensive, and failing to plan can be detrimental to a family or heart breaking to the child. Some families choose not to send their children to college, but would rather help them save for a down payment on a home or a large wedding. Whatever the goal is, you have account options to correspond with your vision. Look for 529 accounts, UTMA or UGMA accounts, Coverdell accounts, etc. The investments you put into these accounts will vary on your child's age and the goal of the account. Remember, it may be tempting to skip the emergency fund and come straight to this step, but you should consider "putting the oxygen mask on yourself first" before helping your child.
7. Non-deductible Contributions
This is where the Roth IRA and Roth 401k comes in. A Roth component has eligibility requirements set forth by the IRS, so again double check that you are within the limits. If you are, then great! Definitely consider opening a Roth IRA and contributing the maximum amount. Roth IRAs are after-tax accounts and have different rules than a Traditional IRA. You will ideally be using your Roth IRA to fund your retirement after all of your other resources have been exhausted, and you are in a lower income bracket. Roth IRAs, like Health Savings Accounts, are also great vehicles for passing wealth to your beneficiaries. Just remember to double check those eligibility requirements. Again, the investments here will want to be long-term and diversified. Look for low-cost investments Follow your financial plan and your Investment Policy Statement as your guide.
8. Other Taxable Accounts
If you are reading this, that means you've saved as much as you can in steps 1-7. It probably took you a few years to get to this point, and you now have an "avalanche" of savings. You have a healthy emergency fund, you are saving for your children and future health, and you still have money to invest (aka save). Congratulations, you are further along than most Americans! Saving beyond this point has no eligibility requirements or restrictions. However, I want you to remember your financial goals. Each goal will have a different asset assigned to help you reach that goal. Imagine that you have a goal of buying a vacation property in a year. Do you want to invest your savings in bitcoin to fund this property? Probably not! Taxable investing should not be gambling with the stock market, you should still have a clearly defined objective and plan for investing. Also remember that any gains you realize (unrealized gains do not have tax consequences because you haven't actually sold anything) will be taxed. The same is true for any income derived from the asset, like dividends or profit sharing. Even though you've already been taxed on the money from your salary or other source, you'll still need to pay taxes on gains. Talk to your CPA or financial advisor BEFORE you get to this point to ensure that you are not unnecessarily increasing your tax liability. Many retail investors found a surprising tax bill at the end of the year because they were day trading during the pandemic. Don't let this be you!
Investing is a byproduct of saving. We invest our savings accounts in order to earn additional yield, keep up with inflation, and help us realize our life goals. It takes a well-disciplined investor in order to maximize all of the tools available to you.
If you are looking for a professional to help you craft a tailored investment portfolio, give me a call or send me an email at cgamache@audaxwealth.com.
Our final article discusses the glue that holds all of the InvestHER series together; the idea of investing in yourself!
