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.
Many financial planners stress the notion of “tax diversity” in retirement. 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.
Mortgages. Paying off a mortgage early is a surprisingly controversial topic. The interest rate is an important consideration. Today’s historically low interest rates, and the increase in the standard deduction, make the tax benefit of mortgages less attractive than in years past. Many retirees love the idea of retiring debt-free, while some financial planners recommend continuing to carry mortgage debt and instead using extra cash for investment opportunities or as a reserve in case of emergencies.
Cash accounts. My wife and I became adults when Christmas Club and Vacation Club savings accounts were still a thing. My company had a credit union that made it easy to contribute to these accounts. In addition, my wife has always stressed saving for home maintenance and improvements. Yes, as a couple, we were fine examples of mental accounting.
We’ve now simplified our finances and have just a single money market account. The account is connected to a rewards credit card, which we use to pay for as many expenses as possible. Still, it’s hard to make a strong case for funding savings and money market accounts: We don’t earn a whole lot of interest.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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the most important part of this article is the first paragraph in my opinion. All the financial engineering is certainly useful, but it all comes together and starts with a frugal mindset for most folks born with regular karma. The mindset of living frugally today and delaying gratification until many many years down the road leads to the success of many of readers on this blog.
the secret, if you bother to look for it, is that you don’t need much money to experience happiness today. The money that is invested and accumulated will help smooth out the steep valleys we all experience in life and keep our days lighthearted and sleep refreshing.
My marginal tax rate jumped when my wife died. I have always chosen a Roth over maxing my 403B for tax diversification. It is beginning to pay off as I am now in the 24% marginal rate as a single due to RMDs. Also, I am fighting the medicare penalty which was not a problem before I was widowed. The Roth is helping me there so far. Finally, my son would be stuck in a very high marginal tax rate on my death since congress changed the stretch IRA to 10 years. The Roth will certainly help there.
In short, I would put the Roth ahead of maxing a 401k/403B. I am in general agreement with everything else you proposed.
Great list that many people can benefit from reading and following. But you say the Roth is a bet on marginal tax rates. True for contributions, but what about earnings in the account? If a person can save a higher percentage by going pre-tax I guess it’s possible to come out ahead with pre-tax saving, but if a worker is saving say 10% pre-tax or Roth or both close to the same percentage, won’t the tax-free earnings over a working career always beat earnings taxed as ordinary income? I would add one item to your list, but I’m not sure where; non retirement investments.
With any luck, this should explain the math:
https://humbledollar.com/money-guide/how-to-think-about-that-tax-deduction/
Richard,
Thanks. I had non-retirement investments in my original list, and somehow lost it in re-write! I agree and even encourage my young nieces and nephews to start a low-cost, low initial investment, low regular investment plan like Betterment. I think that’s a good spot for a grandparent or uncle to help out.
Everything i have learned about Roth vs traditional is that they are equal if the tax rates are the same at deposit and withdrawal. I think Jonathan’s example shows that. But we all know things will change over time, and other considerations may win the argument. I have to admit that the thought of withdrawing from our traditional retirement accounts in the coming years causes me great angst, due to taxes. Totally irrational I admit.
I agree overall, but I’m not sure why you would fund an emergency fund before paying off high-interest debt? Isn’t high-interest debt an emergency?
Also, the question of whether it’s better to invest in a Roth or a traditional IRA is a surprisingly complicated question to answer. Mathematically, there’s a case to be made that a Traditional IRA is better if you’re financially savvy, frugal, and play your cards right: https://www.madfientist.com/traditional-ira-vs-roth-ira/
However, humans aren’t robots, so we need to consider psychological factors as well. And the Roth has a number of advantages that the traditional IRA doesn’t (like being able to withdraw contributions penalty free at any time).So I think your recommendation to invest in a Roth if you are in a lower marginal tax bracket and to switch to a traditional if you get bumped to a higher bracket makes a lot of sense in practice.
The answer to the high interest debt vs emergency fund is pretty straight forward. For many people, the high interest debt (ie credit cards) is directly due to not having an emergency fund to pay sudden expenses. The only place to turn is credit cards, so if they are paid off and another emergency comes, the person is right back in the same place they were before. The creation of an emergency fund can stop the viscous cycle, and while it will take longer to pay off the high-interest debt the desired effect is that it is a one time event going forward.
1. It is difficult to establish an emergency fund while making minimum payments.
2. You will be making high interest payments longer while you are establishing your emergency fund.
3. If you have to tap your emergency fund before paying off your high interest credit card balance it will take you even longer to pay off your credit card balance.
I put my last semester of college on a credit card. First thing I did after college was pay that off… not build an EF.
Thanks Thomas. My hope would be that people fund the emergency fund before they build up the credit card debt, but I know that is not always realistic. I’ve seen this plan work for new college grads with good jobs and an understanding of the value of saving. I’ve also seen families who got into a lot of debt. They often need help to build a plan that takes into account their income security, and attacks debt and savings at the same time. I have a good friend who is an excellent financial planner who does a lot of pro bono work thin our area for families in trouble, and I’m amazed at how she can turn families around.
Young people, starting out with modest incomes and hence able to invest lesser amounts than those with higher incomes, would be better off investing in a Regular IRA because, in this way, the low amounts invested are still greater than they would be with a Roth IRA. The greater relative $ invested over time as opposed to investing in a Roth is compounded over time. The additional compounded $ can greatly enlarge the amount of savings down the line. Given the levels of median household income in the US, a significant portion of the population of people filing a joint return would be paying a 12% marginal rate up to an income of $80,250 based on 2020 tax tables. Effective tax rate, not marginal rate, is the key factor when deciding whether or not to invest in a Roth.
I understand that, thanks to the tax deduction, a young adult (or indeed any person) would be able to invest more in a traditional IRA than in a Roth, assuming they invest the tax savings and assuming they aren’t already maxing out the account. But what about the taxes owed on the traditional IRA upon withdrawal? Surely that tilts the odds in favor or the Roth for a young person on a low income who will likely be taxed at a higher rate down the road?
The point is this: a lot of people are not going to getting into those stratospheric tax rates that you are envisioning down the road. All you have to do is look at the income/net worth inequality in the US. Plus, what is the present value of those tax dollars paid when you are in your mid to late 60’s, 70’s and 80’s versus the present value of those additional taxes paid in your 20’s and 30’s when you are funding that Roth IRA.
I agree with you both to some degree.
A Roth IRA for as long as earnings are modest, and taxes owed are close to nothing.
A traditional IRA as soon as you are paying over 12% marginal. You are correct that most people will never save enough to make the Roth IRA worth it.
However, you have to count for sampling. If you are the type of person who starts saving at a young age, your chances of becoming a multi-millionaire increase significantly, even with a modest salary. This is why I’d suggest that young savers may want to contribute to their Roth even while paying the lowest individual rates. Once they get bumped up above the 12% bracket, or if they didn’t start in their 20’s, then I generally agree with using traditional.
Good article. I generally agree – and for knowledgeable individuals, such as those reading this post, these are all fine recommendations.
However, others may want to consider a different hierarchy. Consider:
– According to the American Payroll Association annual study, 70% of Americans live paycheck to paycheck – where they would have some or significant difficulty meeting their bills if their next paycheck was DELAYED one week!
– According to Vanguard, How America Saves, 21% of eligible employees do not save in their employer sponsored plan, and another 1/3rd do not save enough to get the full employer financial support.
– According to the Department of Labor, median tenure of American workers has been < 5 years for more than the past 5 decades. On average, and averages can be deceiving, the DOL/BLS confirms that the average worker age 50 has had 12 different employers. So, my suggestion is to prioritize the 401k and HSAs while you are eligible. Make sure at least one 401k you participate in provides 21st Century loan functionality (electronic banking, etc.) so that you can not only take loans and continue payments after separation, but also initiate a loan post separation. It becomes the "Bank of Richard". Your bank offers "liquidity without leakage, along the way to and throughout retirement". Allows you to continue to defer taxation, and potentially, avoid penalty taxes - instead of taking a distribution to meet a pre-retirement need. Interestingly, if the plan loan interest rate is GREATER than the return on fixed income investments in the plan, and LESS than the interest rate on a loan from a commercial source, a plan loan can improve both Household Wealth AND retirement preparation.
We went close to 15 years without a true emergency fund, using a heloc. We were throwing money at long term growth, so I don’t regret it, but it’s a dangerous way to live.
It can be so much harder than anyone would conceive to turn the corner on negative cash flow, but now our EF has 3 months and growing, all funded this year.
The closer retirement gets to a reality, the more I like the idea of a really big, healthy EF sitting there to bridge us to SS claiming.