Building Blocks of the Rightirement
When building a quality football team, you want different attributes at different positions. Generally, field goal kickers do not have the skills and physical attributes that would also make them good offensive lineman or tight-ends, nor do cornerbacks generally make good defensive lineman. Similarly, creating a quality blend of asset vehicles will perform much better and give you both tax advantages, growth of capital and flexibility to use when needed. It should be noted that we are not discussing specific asset types, i.e. stocks vs. bonds here, rather than the vehicle or bucket into which we plan to put them. Actual assets is another important subject that will be addressed later.
Asset building blocks refer to different savings and investment vehicles that are important to 1) keep your money safe, 2) grow your money, 3) reduce your taxes and 4) allow flexible access to the money.
These building blocks include
- Checking/savings account
- 401k/457b or other company/government sponsored retirement plan
- Traditional IRA
- Roth IRA/Roth 401k
- Health Savings Account
- Flexible Spending Account
- Taxable Brokerage Account
- Cash in hand
- Real Estate
- Alternative Investments
|Fund Vehicle classification||Annual Contribution Limit (2016)|
|Health Savings Account||$3350 Individual / $6750 Family|
|Flexible Spending Account||$2550|
|Cash in hand||None|
Table of benefits for each:
The below table rates each investment vehicle on a scale of 1-5, with 5 being the highest and most desirable to 1 being the worst/least desirable. Investment accounts assume a mix of stocks and bonds more heavily weighted to stocks.
|Fund Vehicle classification||Ease of Access||Tax Advantage||Safety from Loss||Inflation Protection||Contribution Limits||Average Annual Return|
|Roth IRA/Roth 401k||3||3||2||4||3 /
|Health Savings Account||3||5||2||4||1||5|
|Cash in hand||5||1||4||1||5||1|
Looking at the above table, there are a wide range of characteristics for each separate vehicle class, so the goal is to build a good personal financial system based on your goals and needs. Let’s consider each separately.
Before continuing on, it’s important to note that this is a blog and not a certified financial planner. I do not know you or know your particular life circumstances. These are ideas to consider and if you feel you want to integrate one or more of the items below, you might consider paying a professional to make sure the things discussed herein will work for you in your life.
Ease of Access
Buck Rogers said, “I’m more worried about the return of my money than the return on my money”. Availability of money for withdrawal in certainly important in any investment and we need a certain amount ready to cover emergencies or unexpected life events that can be quite costly. Looking at the ease of access attribute first, it’s no surprise that checking/savings and cash in hand score highly as far as far as easy to access, unless they are held in a Greek or Cypriot bank during a panic.
Money is also fairly easily accessed via taxable accounts and then Health Savings Accounts (HSA). These usually require a few days to transfer to bank accounts, but some HSAs and accounts do have a debit card that would almost merit a 5 on that scale. HSAs ranked a bit lower as qualified withdrawals must be for medical related expenses.
Roth IRA/401ks come next as contributions are always available to withdraw penalty-free, but any earnings can’t be easily withdrawn except under special circumstances. Alternative investments (gold, art, collectibles, guns, etc.) and real-estate round out the bottom as they require finding a buyer to unload.
Next, we evaluate tax advantages of each fund classification. Health Savings Accounts score the highest, since it is possible to not only avoid federal and state taxes, but if done through an employer cafeteria plan, you do not even pay Social Security taxes on HSA contributions. Additionally, any withdrawals for medical purposes are also completely tax-free. It is the only fund class that is widely available and has no tax levied during both the contribution and distribution time frames.
Next are the 401k and traditional IRA vehicles. Both offer tax deferred contributions-lowering your initial taxes now and paying them upon withdrawal. You still pay social security taxes on these contributions, but they are allowed to grow tax free until you start withdrawing them.
Roth IRAs and Roth 401ks follow next. It could be argued that they are equal to traditional 401ks and IRAs, but because their tax advantages are deferred they are considered less optimal for present tax planning. We will discuss a powerful way to harness both the benefits of the traditional and combined with those of the Roth plans to avoid any taxes on such money later. Brokerage accounts score above regular savings accounts simply because long term capital gains and qualified dividends are generally taxed at lower rates in the US than regular interest or income.
Safety From Loss
Assuming that investment accounts hold a mix of stocks and bonds, they will be subject to the risks of the market. These accounts are not generally FDIC insured, unlike the savings and checking accounts that offer depositary insurance. Cash on hand receives a little deduction for risk of loss in fire or by theft.
Purchase protection refers to the fund vehicle being able to maintain the same value after inflation. This is probably the most underestimated risk for the general public in holding cash is that it is almost certainly slowing losing the battle with inflation. Real estate and gold are generally considered to keep pace with inflation.
Another important consideration is how much you are allowed to put into a given fund vehicle. Unlimited is always better, but as a general rule, the more juicy the tax breaks, the more limited the amount you can contribute.
The HSA, which scored the best on the tax advantaged area, scores worst in the contribution limits as it is more restricted in contributions than any of the other options. You must first be enrolled in a high deductible medical insurance plan and not eligible for Medicare or covered by a non-high-deductible plan. You are limited to $3350 for individuals and $6750 for families (plus another $1000 if you’re 55 or older).
Compare that to the limits of $5500 per person for IRAs (both traditional and Roth) and $18,000 for 401ks (traditional or Roth). Traditional IRAs get a slightly lower score than the Roth IRA as they phase out earlier as you move up the income scale. The Roth 401k gets a higher score (4) than the Roth IRA (3) in this instance as it has limits similar to the traditional 401k.
Finally, we need to consider the average return of the money we allocate to different vehicles. Tax deferred or tax-free vehicles invested in a mix of stocks and bonds will return better than almost any other scale-able asset over the long term. Scale-able assets refer to those assets that you can easily buy more at the same rate-buying 5 rare Honus Wagner baseball cards is not a simple or fast process. Similarly, buying 100 more guns will also require additional storage space and might involve a visit from an interested federal agent. Gold only manages to maintain purchasing power, but does not meaningfully appreciate against inflation for long time periods. Cash held in savings or checking accounts will generally lose to inflation, but will continue to grow in an absolute sense as interest is paid. Cash under the mattress or in a safe appreciates not at all.
So considering all these options, how does one pick the best financial vehicle team to put on the field in a not-quite-fantasy competition against life?
Using the team to win the game
Cash is king. The foundation to any person’s financial life is cash. From the groceries we buy to the houses we live in, we created a system of fiat currency wherein we can exchange fancy printed paper and engraved metal alloys for goods and services. We need some level of money that we can quickly access for our daily and monthly needs. Setting aside some cash in a checking or savings account is a good way to maximize our ability to respond to the both the expected expenses as well as the regular irregularities that come our way. Experts generally counsel holding between three and six months worth of expenses in a “safe” account. I lean toward the lower number for reasons explained later.
The diagram below shows pictorially how to set up your saving/investing cash. The simple principle is to fill up each “bucket” until you run out of money in the monthly budget. For example, once the $1000 (or whatever number you pick) emergency savings bucket is full, you next work on filling up your 401k up to the employer match, if available. Continuing on down the waterfall, making sure that if you have an emergency, that you work to refill that bucket before progressing further down the contribution waterfall. The reasoning behind the order of precedence is provided below, however, feel free to modify it to fit your own plan and needs.
After putting together a plan for filling up a reasonable regular expense bucket with some margin for emergencies, I next look to fill up my 401k enough to get my employer match. Many companies match between 25-100% of employee contributions and some match even higher. This is as close to free money as most people are ever offered. This also hits the tax advantaged bonus and starts our money earning a higher average return. Additionally, in a severe pinch we can get the money back after paying taxes and a 10% early withdrawal fee. Not ideal, but it’s better than starving.
After we’ve gotten our full employer’s match, we then move on to filling up our HSA bucket to the max. Why this? As explained earlier and often, the HSA has a great tax benefit and will allow us to respond to any emergencies requiring medical expenses. Most people who do go bankrupt have experienced medical expenses that ultimately sank their financial boat, so stockpiling some extra money here could save you lots of headaches later. Additionally, many HSAs allow you to invest the money sitting here to allow it to grow until it is needed.
After filling up the HSA, we then look to the IRA option. I prefer the traditional option if you’re in a tax bracket higher than 10%. This is simply because your tax deduction is based on the tax rate of last dollars you put in, which are generally higher than the first dollars. Also, withdrawals from IRAs generally come out after you’re retired and would be the first dollars you would use and would be taxed at a lower rate. If you are in the 10% bracket and can spare the money, by all means hit the Roth IRA hard as it will help you significantly, and you still might get a current tax break through the Retirement Saver’s Credit.
I prefer loading up the IRA before finishing the 401k because there are generally better investment options, lower fees and are easier to set up the Roth IRA pipeline, though some of my 401k funds are through Vanguard with fees lower than I can get through an IRA. I like plain, simple Vanguard mutual funds and ETFs as they are extremely efficient at growing my money and keeping me from making stupid mistakes.
If you’ve successfully built up some cash reserves in an emergency fund, got the full employer match at work, maxed out the HSA and the IRAs, good for you! You are in a relatively exclusive club of financially savvy individuals who have thought hard and made some sacrifices in the hope of long term benefits. Take a moment to pat yourself on the back. Now, go max out the rest of your 401k. And your spouse’s if he or she has one.
Still got money to burn on that crystal chandelier and that $70,000 4×4 quad cab dually truck to commute to work? How about starting the taxable investment account, instead. While not as sexy or screaming of affluence, this will help continue to grow your money long term and backstop your cash emergency fund and possibly get you out of that soul-crushing job a few years or decades early. This is also the bottom of the waterfall and since there’s no limit to how much you can put in this account.
You could also use some of that taxable investment money to diversify into real estate-either paying off your mortgage or buying a place to rent and becoming a landlord. Getting your mortgage debt paid off will not only help from a cash flow perspective as you eliminate one of your biggest monthly expenses, but you all but eliminate worrying about becoming homeless. You also lower your income threshold of becoming financially independent, which is fantastic.
Following the above strategy won’t make you wealthy overnight, but it will likely do so over time. It will balance flexibility with lower taxes. It will provide discipline to keep from spending money on unnecessary trinkets.