Where to invest your savings

You've made the smart decision to save money automatically. Now you need to make the next decision of where to save. 

This article will be broken up into two main categories.  

 

1) Understanding the types of accounts you can save in and

2) When you should save into each account. 

Before we start, let's clarify a few details.  

1) Since investing is a long term plan and we assume that your invested money will grow over time, we're going to call the money you invest today the Small Dollar. 

We'll call your future invested money the Larger Dollar. 

Today

30 years from Today

2) Beyond simply just saving and investing, it is extremely powerful to focus on your Tax Liability.  Both now and in the future. 

 

This tax liability will be the underlying focus of this article.  

Understanding the types of accounts

 

You have many accounts that you can save in, but they fall into three main categories.  

  • Pre-Tax

  • Post-Tax

  • Taxable

Pre-Tax - you pay taxes LATER

(the larger dollar)

Post-Tax - you pay taxes NOW

(the smaller dollar)

Taxable - you pay taxes LATER

(only on gains)

Pre-Tax

Think of your 401k, 403b, or IRA.  

When you add money to these accounts, you Deduct your contributions from your income.  

IE, if you make $100k this year and you contribute $5k to your 401k, you deduct the $5k from your income when you file your taxes.  

You end up paying taxes based off a $95k income.  

You DON'T pay taxes Today

You pay taxes in the Future

Since you're deferring your taxes to the future, it makes sense to maximize your savings in these types of accounts when:

  • You are in a mid to high tax bracket.

  • Have a shorter length of time before you plan to withdraw the money.  (closer to retirement)

A few things to note about this type of account:

  • These often end up being our largest accounts because many of us setup automatic savings into our employer retirement plans and don't think much about it after that. 

  • You will be required to start taking distributions from this account when you reach age 72.  

Post-Tax

Think of your Roth IRA, Roth 401k, or Roth 403b.  

Your contributions to these accounts are after tax. You get no tax deduction. 

IE, if you make $100k this year and you contribute $5k to your Roth IRA, you DO NOT deduct the $5k from your income when you file your taxes.  

You end up paying taxes based off your full $100k income.  

You pay taxes Today

You DO NOT pay taxes in the Future

Since you're paying the taxes now, it makes sense to maximize your savings in these types of accounts when:

  • You are in a low tax bracket

  • Have a longer length of time before you plan to withdraw the money.  (farther from retirement)

A few things to note about this type of account:

  • Since a lot of the benefits of financial planning stems from tax planning, maximizing these accounts is important long term. 

  • You are NOT required to take any money from this account ever.

Taxable Accounts

Think of your checking & savings account or brokerage investment account.  

Your contributions to these accounts is after tax. You get no tax deduction. 

IE, if you make $100k this year and you contribute $5k to your Taxable Account, you DO NOT deduct the $5k from your income when you file your taxes.  

You end up paying taxes based off your full $100k income.  

The real power of these accounts comes from how you pay the taxes. 

You only pay taxes on the GAINS, and it's at a lower rate than your income tax rate. *assuming you've held your investment for more than one year. 

(Taxes paid on gains)

You pay DON'T pay taxes Today

You pay taxes on the GAINS, and only when you "realize" the gain. 

Let's unpack a few of the tax caveats first.  

1) I was over simplifying earlier when I said you "only pay taxes when you realize the gain." 

In reality, you'll likely receive a 1099 every year with taxable income for any interest, dividends or capital gains if you're investing into some type of actively managed mutual fund.  

So for simplicity to illustrate this I'm writing as if you bought one single, non dividend paying stock

2) The taxes owed are broken up into Short term and Long term Capital gains.  

Short Term Capital Gains

Held less than one year

If you buy XYZ stock for $10 / share on Jan 1, 2020 and sell it for $15 / share anytime in 2020, you owe taxes on:

The $5 in gains payable at:

Your Ordinary Income Tax Bracket

($5 Taxes owed)

$10

$15

Your current tax bracket.

Long Term Capital Gains

Held more than one year

If you buy XYZ stock for $10 / share on Jan 1, 2020 and sell it for $15 / share anytime after 2020, you owe taxes on:

The $5 in gains payable at:

A Preferred Tax  rate. 

($5 Taxes owed)

$10

$15

A Preferred Tax rate.

A few things to note about this type of account:

  • Like your checking and savings, you have access to this money anytime. There are no restrictions prior to 59 1/2 years old like there are with the pre-tax and post-tax accounts. 

  • Building up this account with time can be incredibly powerful in retirement because you can have more control of your taxes. More on that here (write article)

Thanks for sticking with me so far. Understanding the types of accounts may be a bit boring, but it's important. 

When you should save into each account

 

First, are you a: 

Normal cash flow saver?

High cash flow saver? 

Normal Cash Flow Saver

When I say normal cash flow saver, I mean someone who is saving less than the total of:

Roth contribution limits ($6,000 if you're under 50 & $7,000 if you're over 50 years old) *2020 numbers

Plus

The amount you need to contribute to your company retirement plan to get the Employer Match.  

If this is you, your savings strategy is relatively easy.  

Typically you should save:

First to build up your Emergency Reserves

                   Then up to your Employer Match in your retirement plan.

                             Then up to your Roth Contribution Limits

If you're saving more money than this, congratulations! 

You're a High Cash Flow Saver.  

High Cash Flow Saver

We don't really need to define the high cash flow saver since if you've read this far, this is probably you.  

I'm assuming you already have your emergency reserves built up to your "Magic Number". If you don't know what your "Magic Number" is, check out this article

You've maxed out your Employer Match

If you're eligible to contribute to a Roth, you should max out your contributions. 

  • Single filer income between $124k - $139k

  • Married filer income between $196k - $206k

If after all of this you still have more money to save, you enter the "Grey Area."

Up until now, savings strategy was relatively easy.  

You built up an emergency savings because it's a smart financial move. 

You've saved up to the employer match to receive the matching funds. 

And you've saved into a Roth because it's smart to do so while you're in a relatively low tax bracket

The "Grey Area" is where you need to understand what your financial goals are a bit more clearly. 

Do you contribute your excess savings to:

Your Pre-Tax Employer Plan and receive a tax deduction?

A Taxable account and keep your funds flexible & available?

Generally I recommend putting the excess savings into:

Your Employer Plan if:

  • You are in a high tax bracket (32% or higher)

  • You don't have any short term financial goals. 

  • You just want to keep things simple. (401k contributions are easier than setting up another account and manually transferring money)

A Taxable Account if:

  • You're in a mid range tax bracket (22% - 24%)

  • You may have short term financial goals such as buying a house, a car etc.

  • If you plan to retire prior to taking Social Security (which I hope is everyone.) Read why here (write article)

Pre-Tax Account

Taxable Account

Personally, I tend to lean more towards funding the Taxable account often times. 

Retirement planning is ultimately a bunch of educated guesses about what we’re doing currently, rolled together with a bunch of educated guesses about what we’ll be doing 30 years from now. 

It's impossible to predict your future spending habits, future tax rates, investment and inflation rates among thousands of other unknown variables.  

I've learned in my years as a financial planner that we don't always have to make the "perfect" financial decision. You need to make the right decision for you. 

Plans change. 

Life throws you curve balls. 

I think the flexibility alone of the Taxable Account is a big advantage. 

Beyond the flexibility, people who are lucky enough to build up a large taxable account can do some incredible financial planning strategies when they retire. 

The Taxable Account is a tool that can help you accomplish what I believe are some of the most powerful financial planning strategies possible.  

If you'd like an example, check out this article next. WHY YOU NEED A TAXABLE ACCOUNT. 

I also believe that if you're in this situation as a High Cash Flow Saver, you could be best served by working with a Financial Planner if you're not already. 

If you're convinced that this may be a good idea for you, but don't know how to get started feel free to schedule a phone call.  We're happy to help...

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© Greater Good Financial 2020


Advisory services offered through Resources Investment Advisors, LLC. ("RIA"), an SEC-registered investment adviser.