I enjoy taking an adaptive approach to my savings. That is, every hard-earned dollar that I save is invested for a specific purpose that will help improve my financial needs at some point down the road.
This article is targeted for individuals who would like to learn about opportunities for saving outside of retirement accounts. Diversifying investments into accounts with differing tax treatments (tax-advantaged and taxable accounts) can help to improve financial security.
Short-term: Planned (and unplanned) expenses
An important foundation to any financial strategy is setting aside enough cash to create a buffer between you and life’s unexpected events. If you lose your job, become ill, or have a large expense such as a car repair, you might benefit from having liquid cash in an emergency fund to ride through that period.
Cash and cash alternatives are generally considered to be safe for protecting your investment principal. However, the risk is inflation eroding the purchasing power of cash over time. This means every dollar parked in cash will buy less “stuff” as time goes on.
In determining the size of your emergency fund, consider the length of time you could live on it with your current expenses. With two incomes, you might begin with three to six months.
Longer-term: Preparing for expenses greater than one year
Tax-deferred vs taxable investment accounts
Tax-deferred accounts, such as a traditional 401k, may provide an up-front tax benefit for contributions while deferring income taxes until there is a withdrawal. In contrast, taxable accounts do not have any specific tax benefits. The trade-off is taxable accounts can offer fewer restrictions for accessing funds because any withdrawal is not taxable. In turn, these accounts may offer greater flexibility in saving for long-term objectives.
The tax treatment on the investment gain depends on the length of time that you held an asset when you choose to sell it. Taxable accounts have the advantage of favorable tax rates on capital gains (vs ordinary income tax rates) if you hold investments in the account for over one year. If you sell an investment within a year or less of purchase, any gains will be subject to short-term capital gains taxed at your ordinary income tax bracket.
Your savings rate to taxable accounts might be partly determined by whether you want flexibility in taking money out before retirement. For example, investing toward a goal to fund a home renovation or car purchase in five years might put emphasis on saving to taxable accounts. This strategy can allow you to put some cash to work to hedge against inflation potentially reducing purchasing power, and you can distribute money from the taxable account at any time without penalty or tax on the withdrawal itself.
Our financial professionals can work with you to help you understand the different types of investments that are available to you. We invite you to contact us today to learn more about how we can help to develop a plan to meet your objectives in the most tax efficient way.