Hierarchy of Savings
Richard Connor | March 4, 2021 EARLY IN MY CAREER, one of my mentors at work used to talk about “excess paychecks.” He was a single, senior engineer who lived frugally. Back then, the concept seemed ridiculous to me. But I’ve come to realize he was right:
Most of us don’t need every dollar we’re paid for living expenses, so we should think carefully about where to stash the excess. That notion came to mind recently when taking to a friend. She’s five years from retirement, concerned about today’s high stock market valuations and wondering if maxing out her 401(k) is her best choice. Would it be smarter, she wondered, to use her extra money to pay down consumer debt, pay ahead on her mortgage or make some home improvements?
Here’s my take on the “hierarchy of savings”:
Emergency fund. I would make this a top priority. An annual Federal Reserve survey has found that 37% of U.S. families can’t handle an unexpected $400 expense. The pandemic’s economic fallout has highlighted how perilous that can be. My advice: Depending on how secure your job is, set aside between three and six months of living expenses in conservative investments as an emergency reserve.
High-interest debt. After you’ve established an emergency fund, it’s time to attack high-cost debt. For most of us, that means credit card balances. Even in today’s low-rate environment, credit cards charge an average 16%, according to Bankrate. Paying down high-interest debt is smart financially, plus it provides a great psychic win.
Employer retirement plans. There’s a host of tax-favored employment-based retirement plans, including for self-employed individuals. The standard financial guidance is to invest at least enough to capture any matching employer contribution. I recommend to my sons that they start with a minimum 10% of their income.
Health savings accounts. As I’ve written before, I’m a fan of health savings accounts, or HSAs. Used properly, they provide a triple tax savings—an initial tax deduction, tax-deferred growth and tax-free withdrawals if the money is used for qualifying medical expenses. Employers sometimes offer incentive contributions to an HSA, often coupled with a wellness program. To be eligible to fund an HSA, you need to enroll in a high-deductible health plan (HDHP). Such health insurance isn’t always offered to employees. If it is, I’ve found that a low-premium HDHP, coupled with an HSA, can be a cost-effective way to pay for health care.
Employer retirement plans (again). If you’ve tackled the items above and still have excess funds, maxing out your 401(k) or similar plan is a good way to go. If you fund a traditional retirement account, you can get an immediate tax deduction. For many, their withdrawals in retirement will be taxed at a lower rate than they’re paying today, which means the initial tax deduction more than pays for the eventual tax bill.
Roth IRA. Contributing to a Roth IRA or Roth 401(k) is a bet that your marginal tax rate today is lower than it will be in retirement. This bet can make particular sense for younger savers with relatively modest incomes. As you progress in your career and your salary increases, so will your marginal tax rate—at which point traditional, tax-deductible retirement accounts may be more appealing. Having both traditional and Roth retirement accounts gives you the opportunity to better manage your annual retirement tax bill. Moreover, you don’t need to take required minimum distributions from a Roth IRA. Roth accounts also pass tax-free to your heirs.
College fund. Saving for your children’s college is a great thing to do. But it’s probably not your highest financial priority. Have you paid the monthly bills, paid off credit cards and saved for retirement? If you still have money left over, a 529 plan isn’t a bad way to go, because it offers tax-free growth if the money’s used for qualifying education expenses.
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