We have all heard the stats. As COVID has wreaked havoc over the past year, the personal savings rate in the US has spiked – so much so that it hit record levels in 2020. Historically, according to JP Morgan, Americans tend to save a higher rate of income during recessionary periods, and the COVID recession fit this trend and then some – hitting 15% of gross income, on average.
No doubt, this was partially fueled by record levels of government transfer payments (stimulus checks, etc.), as well as realities of being locked down. Regardless of how it came it to be, it is – and now the question many of you are asking is, “How do I best allocate this savings?”
Decidedly, the answer to this is the ever welcomed “it depends.” Every situation is unique, and how you allocate is going to depend on your goals. That said, there are general ways to approach this to help you save, invest, and earn in the most tax-efficient manner. We’re going to use today’s financial planning briefing to look at these options. We’ll start with a very good chart from JP Morgan’s 2021 “Guide to Retirement,” an annual publication that is one of the best in the business for helping us see and communicate trends and opportunities in retirement planning.
Let’s walk through this step-by-step, starting at the bottom.
- Emergency reserve – this one certainly came to the fore over the past year as COVID wreaked havoc on all parts of the economy and daily living. Those with emergency reserves were better able to bridge the gap until jobs returned, enhanced unemployment benefits kicked-in, or stimulus checks started flowing. In today’s low-yield (zero-yield) environment, keeping 3-6 months of core living expenses sitting in a checking/savings account can be painful, but we can help you look at structuring these reserves such that you maintain liquidity and safety of principal while earning something better than 0%. One other note on this. When you see “3-6 months” know that this is a rule of thumb. A more personalized number can be had by looking at the nature of your expenses, security of your income (dual earner vs. single makes a big difference), and other resources at your disposal.
- Health Savings Account – For those select few who are eligible to contribute to an HSA and have an employer who will match some or all of your contribution, this is by far the most tax-preferred way to start saving beyond your emergency reserves. HSAs enjoy a “triple tax advantage,” something you will not find with any other account type. Contributions done through payroll have a fourth advantage in that they aren’t subject to FICA taxes. We wrote about these in detail in late-2019, and we encourage you to access that piece to learn more. Your goal here should be to first contribute enough to maximize any available match. You’ll then work your way up the chart, and you’ll find that finishing out your annual max contribution is not far away.
- Defined contribution savings (e.g. 401(k)) – Once you’ve hit the initial goal around your HSA, you’ll want to make sure you are contributing enough to your 401(k)/403(b) to maximize any employer match. Nearly all of you that we have talked to do this already, but we would be remiss to not have you make sure it is still the case for you. Not doing so literally leaves free money on the table and can significantly work against your long-term financial goals. Note that within the 401(k), you will likely have the option of Traditional (pre-tax) or Roth (after-tax). We are happy to help you think through which of these options best suits your needs.
- Pay down higher interest loans – Whether you pay them down or refinance at today’s ultra-low rates, you should prioritize getting rid of debt that carries high interest rates. Credit card balances, old student loans, personal loans, etc. – anything over ~5-6% warrants consideration here. While these loans may have been warranted and wise when first taken, now would be the time to get them paid off. No need to have excess funds sitting in bank while paying exorbitant interest each year. High levels of debt only limit your financial freedom and flexibility moving forward.
- Additional HSA contributions – By now, you have partially funded that HSA, if you have one. Now it is time to finish funding it. For 2020 and 2021, the annual contribution limits are $3,550/$7,100 (individual/family) and $3,600/$7,200, respectively. Ideally, you then invest these funds for the long-term, though you may opt to use them to meet current out-of-pocket health care expenses (or a combo of the two). This is up to you and your resources at hand. You may be asking why this lands ahead of 401(k) savings. The reasons are that HSAs enjoy greater tax advantages and can be used in retirement for non-health care spending if you choose. Doing this makes them just the same as a 401(k), but with the enhancement of adding benefits for health care spending.
- Additional Defined Contribution savings – The annual max on a 401(k) is $19,500 (+$6,000 catch-up if age 50 or older). With few exceptions (e.g. Microsoft), most employer matches max out well before you contribute the annual max. However, if you have accomplished #3-5 above, it’s time to consider adding to that 401(k) contribution, such that you approach or even hit the annual max.
- Pay down lower interest debt – This one is a bit more nuanced. Paying down loans like student debt, car loans, etc. definitely are worth of consideration here. A fixed-rate mortgage at 3% (or less) – that’s debatable. Regardless, if you’ve accomplished all of the goals listed above and still have excess cash flow or cash in the bank, it’s time to take a close look at paying down debt.
- IRA – For many in the position of doing all that has already been listed, funding an IRA may not be possible – not due to a lack of cash, but because of rules governing contributions. That said, there are still a couple of ways to utilize an IRA here. One is through a spousal contribution if one spouse is not working (subject to some income limits). The other is the “backdoor Roth,” which is a way of getting funds into your Roth even if you are over the annual income limits that would otherwise prevent you from funding that account. While it sounds nefarious or “shady,” this method is fully endorsed by the IRS, so no need to worry that you’ll get hauled off or fined for taking advantage of it. The mechanics of this are a bit complex and it is not a suitable maneuver for some. However, we are happy to help you figure out if it is right for you.
- Taxable account – This is your old-fashioned “brokerage account.” It receives no special tax treatment, which is why you find it here below these other eight options. However, what it lacks in tax-preferences, it makes up for in flexibility. No contribution limits, no early withdrawal penalties, complete liquidity, and total freedom as to what you invest in. In fact, these qualities elevate it much higher on this priority list for some – such as those saving toward big goals like a house down payment, a vacation home, starting a business, or more.
That last point about the taxable account is what I want to close with. It’s a great reminder that lists like we’ve shared here are great, but they have limitations. They don’t know your personal situation and the goals you are working towards. These nine items can be shuffled in many ways to better suit your own needs, resources, goals, and values - and, in fact, other savings vehicles may also fit in for you (e.g. whole life insurance, annuities, etc.). That’s where great financial planning comes in. We invite you to engage with us to start (or refine) your plan as you come out of this turbulent past year. If you are like many of our clients, this past year has helped you to redefine your goals and values. Now let’s make a plan that reflects this and gears you up to work towards them in the most financially prudent manner.