Published On: September 2, 2020
Written by: Ben Atwater and Matt Malick
There is a legitimate argument that Americans do not save enough because of structural factors. For a significant percentage of the population their wages simply do not allow them to save, even for an emergency. In 2017, a Federal Reserve report said 41% of American households cannot cover a $400 emergency expense.
For the mass affluent, a structural problem with saving is the lack of a widespread definition of what successful saving even is. For most of us, saving is an artificial construct. For example, someone might save 3% of her wages into a 401(k) because her company matches the 3%. In doing so, she is saving 6% of her wages. Does this make her a prodigious saver?
So much time is spent in articles, television segments, podcasts, etc. on investment speculation, but relatively little time is spent on saving. You will see segments about this stock and that stock, Federal Reserve policy, trade wars, political tensions, but you will see little on basic personal finance, like saving. Imagine if the financial news network CNBC spent a full day broadcasting the merits of saving 10% of your pay. Nobody would watch.
A goal of saving 10% of your income is an excellent target. High earners should push their saving rate to 20%.
Whether you are forty years from retirement or five years from retirement, saving should be a priority. The adage to “pay yourself first” is a good one. But, how best to “pay yourself first”? In this email we offer a hierarchy of saving for most individuals.
Abraham Maslow created a theory in 1943 to rank humans’ basic needs in life. Maslow’s “Hierarchy of Needs” is typically presented as a pyramid, with primitive needs for survival at the bottom. Upon satisfying each level, one can move up the pyramid and fulfill more complex needs. For example, once a person has air, water and food, he can seek out shelter, followed by more abstract desires such as love, self-esteem and creativity.
Achieving long-term financial goals requires a plan for saving and investing that can be sorted into a similar pyramidal structure. While we are not the first to create a “financial hierarchy of needs,” this iteration focuses exclusively on saving.
Most Americans have access to the same basic investment vehicles, including workplace retirement accounts such as 401(k) and 403(b) plans, traditional and Roth IRAs, 529 plans, brokerage accounts, etc. While every client’s personal situation is unique, this basic “hierarchy of saving” can serve as a guide for most investors to prioritize saving in different types of accounts.
It is worth noting that folks feel an allure to investing outside of financial assets, most commonly in real estate. In some cases, this can be highly profitable, especially in owner-occupied commercial properties or when an investor acquires numerous commercial or residential properties with the scale and expertise in real estate to succeed. However, we have also seen many situations where one-off rental properties or vacation homes become low-returning investments or even a financial burden.
For clients considering a real estate investment, we urge you to contact us to review financial projections for the investment. For others, we believe the following “hierarchy of saving” can provide the means for a prosperous retirement.
Emergency Fund – An emergency fund, which is typically just a bank account that can be tapped in the event of lost income, home/auto repair, health problems, etc., should be the foundation of any personal balance sheet. Most financial advisors recommend enough to cover 3-6 months of expenses, but the exact amount depends on your personal situation and comfort level. For instance, if your wages are variable (e.g. sales commissions) or if your job is not secure, a larger emergency fund may be appropriate.
Emergency funds should be stashed in cash; we often recommend online savings or money market accounts. Bankrate.com is a good source to find the best rates (or the “least bad” rate, in our current low interest rate environment).
Workplace Retirement Plan – Qualified retirement plans, such as 401(k)s and 403(b)s, are offered by employers to encourage retirement saving and they come with several advantages. First, contributions are tax-deductible (more and more plans now offer a post-tax Roth option as well). For wager-earners, this tax deduction is highly valuable. Income taxes are deferred until funds are withdrawn in retirement, when most retirees are in a lower tax bracket.
Second, many plans include an employer “match.” For example, if you contribute at least 4%, an employer may contribute a “matching” 4%. In this example, an investor earns an immediate 100% return on investment.
Third, most plans allow participants to defer up to the IRS limit each year. For 2020, this limit is $19,500 for participants under age 50 with a $6,500 catch-up contribution for those age 50 and above. Some workers, typically at smaller companies or self-employed, can participate in SIMPLE IRAs or SEP IRAs and these plans also carry relatively high contribution limits.
In the category of workplace plans, we will also mention health savings accounts (HSAs). These accounts are an excellent long-term savings opportunity. Maximize contributions to HSAs, but try not to use the funds for medical expenses until after retirement. In the meantime, invest the contributions in the same long-term allocation as your 401(k). Your health savings account can effectively become a second 401(k). Contributions to HSAs are pre-tax and withdrawals for qualified healthcare spending are also not taxable. In 2020 individuals can contribute $3,550 and a family can contribute $7,100 to HSAs. If you are over 55, you can contribute an additional $1,000.
How you should invest a workplace retirement plan depends entirely on your time horizon and risk tolerance. But we almost always recommend maximizing contributions as a first step toward planning for retirement because of their tax-deferral, potential employer match and high contribution limits.
Traditional and Roth IRAs – After you max-out contributions to workplace retirement plans, or if you do not have access to them, then individual retirement accounts (IRAs) should be next on the savings pyramid. Traditional IRAs, where contributions are made pre-tax but future withdrawals are taxed, and Roth IRAs, where contributions are post-tax, but future withdrawals are tax-free, come with much lower contribution limits of $6,000 for people under age 50 and $7,000 for those 50 and above in 2020.
If you and your spouse are covered by a retirement plan at work, then traditional IRA contributions begin to lose their tax deductibility for taxpayers earning an adjusted gross income (AGI) over $65,000 (single) or $104,000 (married filing jointly). If you are not covered by a workplace retirement plan but your spouse is, then the phaseout begins at an AGI of $196,000. Once these contributions lose their deductibility, they become less appealing and investors may want to consider “moving up” the savings pyramid.
Roth contributions also have phaseouts, which begin at AGI of $124,000 (single) or $196,000 (married filing jointly). In the case of Roth IRAs, the IRS disallows contributions entirely above the phaseout limits.
529 Plans – For investors with young children, 529 plans are often the best tool to save for education. They offer tax-free growth if the funds are used for education expenses and sometimes come with a state income tax deduction on contributions. Most plans offer age-based investment options that start aggressive (stock-heavy) and become more conservative (bond and cash-heavy) as a child approaches college age.
However, we rarely recommend saving for children’s education until an adequate amount is contributed toward retirement. Most young people can borrow for college and have a lifetime to pay it back. But you only get one chance at saving for retirement and we have yet to find a financial institution willing to offer “retirement loans” to those who neglected to save. (Although a reverse mortgage is a viable option for retirees who have substantial home equity). If you ultimately find that you have saved enough for retirement, you can always help adult children repay school loans.
Brokerage Account – A valuable, yet often overlooked, savings vehicle is a simple, taxable brokerage account.
Brokerage accounts do not come with any immediate tax benefits like 401(k) and IRA accounts. Each year, the account holder receives a tax form 1099 to report taxable interest, dividends and capital gains to the IRS. But brokerage accounts can be surprisingly tax-efficient if invested appropriately.
On the equity side, a low-turnover strategy leads to modest capital gains in most tax years. And both long-term capital gains and qualified stock dividends are taxed at favorable rates: 0%, 15% or 20%, plus a 3.8% Medicare surtax in certain situations. All these rates would be lower than a taxpayer’s marginal federal income tax rate.
On the fixed income side, coupon (interest) payments are generally taxable as ordinary income, although high earners can utilize municipal bonds, generating tax-free income.
Most importantly, a brokerage account gives you the flexibility to draw from your investments without triggering the ordinary income taxes that result from IRA and 401(k) withdrawals in retirement. For clients hoping to retire early, particularly before Medicare kicks in at age 65, a taxable brokerage account can provide tremendous flexibility to help fund private health insurance premiums and ordinary retirement expenses.
Even among high earners, one of the components missing for many is simply a taxable brokerage account where they make regular contributions. These regular contributions allow for dollar-cost-averaging into an investment strategy which will build long-term wealth simply and tax-efficiently. When it comes to investing in capital markets, a lot of high earners view maximizing tax-deferred retirement accounts as sufficient. For those looking to invest more, they are often seeking to invest in real estate or other businesses. Wealth builders do not have to be businesspeople or landlords. As an alternative, wealth builders need only be savers and passive investors.
As it relates to savings, we believe liquid investable assets are highly underrated. As a wealth builder, the ability to gradually dollar-cost-average into your portfolio, without borrowing to do so, is hard to replicate in other investments. And when it is time to use your wealth for your lifestyle, generating liquidity from a properly diversified portfolio does not rely on large and concentrated liquidations at what may end up being a bad time.