Saving money to meet your goals isn’t always enough to get to where you want to be—you need a savings strategy to make sure your savings are optimizing your progress toward your goals and working for you, not against you. An optimal savings strategy is one that best suits your unique financial profile.
As with most questions regarding your finances, there are many factors to consider because there is no one-size-fits-all approach. To figure out how much to save and where to put your savings money, you must start with a solid understanding of the gap between your current circumstances and your goals for the future. The answers to these important questions can help you build that foundation:
- How much money do you currently earn?
- How much money are you currently saving?
- What are your specific financial goals?
- How much income do you want to have per year in retirement?
The savings and investment vehicles you use for short-term goals and long-term goals should be different. A short-term goal, such as building an emergency fund, buying an upgraded home, or saving for a family vacation typically has no more than a five-year timeline. Long-term goals, such as saving for your children’s college education, paying off a mortgage, or reaching financial independence for retirement, may take you decades to achieve.
Where to Put Your Savings for Short-Term Goals
Most financial professionals recommend you build and maintain an emergency fund that should be easily accessible in the event that you experience a disruption in employment or an unforeseen expense. Saving for a down payment on a home or new vehicle in the near future can also be best accomplished with a higher liquidity savings vehicle.
However, keeping too much cash in traditional savings accounts means that you risk losing purchasing power due to inflation. Traditional savings accounts offer notoriously low rates with the national average in 2021 at .06%, which is nowhere near enough to keep pace with inflation, especially in today’s economic climate.
With these types of short-term financial goals, putting your savings money into a high-yield savings account can allow you to access your money easily while earning an increased interest rate (although typically still not high enough to outpace inflation). Opting for a high-yield savings account through an online bank could return 20-25 times the rates on traditional savings accounts, which is significantly more bang for your buck.
While high liquidity and interest rates are both factors that should inform your short-term savings strategy, addressing long-term financial goals requires different considerations. Saving for retirement, building a college fund for your newborn, or creating a financial legacy to pass on to future generations are decades-long endeavors, and require more calculated strategies to outpace inflation, earn desired returns, and mitigate tax liabilities.
How to Know Whether to Put Your Savings Money in Taxable or Tax-Advantaged Accounts
Most long-term savings goals should be pursued by implementing a sound investment strategy. Building a strong investment portfolio to pursue long-term goals will require appropriate asset allocation and tax planning. From there, you have to decide when it makes sense to invest in taxable or tax-advantaged investment accounts.
From a tax perspective, there are two types of investment accounts—taxable and tax-advantaged. Tax-advantaged accounts like IRAs, 401(k)s, and 529s are common options for people looking to build wealth over time, but they have strict withdrawal restrictions. Accounts with tax advantages allow you to choose whether you benefit more from paying the government now or later, which can significantly minimize your tax bill.
A taxable investment account allows you to purchase securities with the funds inside the account, but any increase in value generated by the securities you own are taxable within the year that they were realized. The primary benefit of a taxable account is flexibility. Without penalties for withdrawing funds, your money is essentially available to you at any time.
Tax rates are based on two factors—how long you held a particular investment and your tax bracket. Investments held for less than one year are subject to short-term capital gains, which are equal to ordinary income tax. Long-term capital gains apply to profits from investments held for a year or more and are currently capped at 20%.
Tax-Advantaged Investment Accounts
IRA’s and 401(k)s are some of the most common tax-advantaged investment accounts, although these may also include other options, such as a 529 plan for college savings. Tax-advantaged investment accounts are either tax-deferred or tax-exempt.
Tax-advantaged accounts are better for long-term financial goals because you cannot withdraw money from them until you reach a certain age or unless you are withdrawing for the intended use (such as college expenses) without incurring a penalty. Generally speaking, any tax-advantaged investment account comes with one of two significant characteristics.
- Tax-deferred accounts (i.e., a traditional IRA) allow you to make tax-deductible contributions which provide the immediate tax benefit of reducing your taxable income for that year.
- Tax-exempt accounts (i.e., a Roth IRA) require after-tax contributions but qualified withdrawals during retirement are not taxable, which means that your investments can grow tax-free.
There is a limit to how much you can contribute annually to each of these accounts. For that reason, many people opt to make a maximum contribution to tax-advantaged accounts each year and then continue to invest in taxable accounts.
Saving With a 401(k) or IRA
Most people have access to a 401(k) through their employer (and self-employed individuals can open a Solo 401(k)). Employers who do offer a workplace-sponsored retirement plan often choose to match employee contributions to their 401(k) up to a certain percentage.
One of the biggest differences between a 401(k) and an IRA are the contribution limits. In 2022, an individual can contribute up to $20,500 to their 401(k) with an additional $6,500 allowable contribution for those over the age of 50. Contribution limits in 2022 to an IRA are significantly lower than a 401(k). The annual contribution limit in 2022 is $6,000, or $7,000 if you’re over the age of 50.
Roth vs. Traditional
401(k)s and IRAs are available as either Roth or traditional accounts, although not all employers offer a Roth 401(k) option. The big question to ask yourself when deciding between a Roth or Traditional investment account is—do you want to pay taxes to the government now or later?
Contributions to a traditional 401(k) or IRA are tax-deductible in the year you make the contribution, providing you an immediate tax break. A Roth account delays the tax advantage to a later date. Money invested in a Roth account can grow tax-free and qualified withdrawals made in retirement will also be exempt.
Eligibility may be the determining factor in opening a Roth IRA because there are income limits associated with contributing to this kind of account. Contributions made by a single filer earning $129,000 per year will be limited, and at $144,000 contributions are prohibited. For married couples filing jointly, the limits are $203,000 and $214,000 respectively.
Whether a Roth account or traditional account is the better option for you depends largely on your taxable income today vs. your predicted taxable income in retirement. For individuals who expect to be in a higher tax bracket in retirement than during their working years, Roth accounts can help you reduce your tax bill in the long run.
So, Where Should You Keep Your Savings?
Deciding where to put your savings money first requires weighing out the pros and cons of liquid savings accounts vs. investment accounts. You’ll need to decide how much cash you need for an emergency fund and how much you can comfortably invest once your emergency fund is fully funded.
From there, you must determine which combination of investment vehicles are most suited to your different financial goals. For most investors, a combination of taxable investment accounts and tax-advantaged investment accounts are typically needed to reach different goals. It’s up to you—and the financial professionals who advise you—to determine the right combination for your situation.
Make Sure Your Savings Strategy Is Suited to Your Goals With Caviness Wealth Management
At Caviness Wealth Management, we know that there are a lot of factors to consider when deciding where to put your savings money. We spend time getting to know your specific circumstances and goals before recommending a comprehensive savings strategy. To see if we can help you optimize your savings strategy to pursue your financial goals, click here to schedule a conversation today.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
