When You Can Afford to Save More, Where Should You Put It?

Written by: Deborah Cartisser

January is a great time to review your budget and determine how much you can save and what to do with the extra savings. Perhaps you received a raise or a bonus at year-end and want to know what to do with the excess.  Where can you make the most significant impact? We get this question a lot, and sometimes the answer depends on your specific circumstances.  Below are some factors to consider when deciding where to deploy additional savings.

Emergency Fund – Yes!

Ensure you have at least 3-6 months of your monthly expenses saved in an emergency fund. This should be kept in a high-yielding cash savings account, preferably separate from your regular checking account. Excess savings can go here until you have reached either the 6-month expense amount or the number that allows you to sleep at night, whichever is larger.

Maximize your retirement savings – Yes!

Be sure you are contributing enough to get the matching contribution that your employer offers and then save enough to make the maximum contribution. Saving for your retirement should be a priority. Overall, you should strive to save at least 15% of your pre-tax pay.  Retirement accounts (IRA, 401(k) & ROTH) all grow tax-deferred, meaning that you don’t pay any tax on the earnings or capital gains within the account. The difference is whether you are using pre-tax money or post-tax money to make the contribution. In an IRA and 401(k) account, you are taking pre-tax money to contribute to the account. These accounts grow tax deferred and you are taxed on the amount you withdraw each year in retirement as though it was salary earnings. In contrast, the ROTH uses post-tax money for contributions, so you don’t get a tax deduction at the time of contribution. The withdrawals you take from your ROTH in retirement are not taxed, unlike in the IRA and 401(k). It’s good to have a mix of taxable and non-taxable accounts to withdraw from in retirement.  Putting money aside in a retirement account is a great long-term plan.  Remember, except for special circumstances,  you won’t be able to access it until after age 59 1/2 without a penalty.

College Savings – Yes, but don’t overfund.

If you have kids, saving for college may be a priority for you. If you want to save for children’s education, 529 plans offer compelling tax-free growth. We advise that clients contribute the maximum amount to their retirement accounts first and then move on to save for college.  Some states have a small tax deduction for contributions to the state-sponsored college savings plan. In Massachusetts, you can deduct up to $1,000 or $2,000 for single or married taxpayers if you make the contributions to the U-fund. In addition to college expenses, you can use 529 accounts to pay for up to $10,000 per year for private school expenses and some vocational training programs. Beware of over-saving in a 529 account. If your child decides they don’t want to go to college or they get scholarship money, you may end up with excess in a college savings account.  The problem is that these accounts impose penalties on non-education related withdrawals. Starting this year, you can convert $6,500 per year up to a lifetime total of $35,000 to a ROTH account in the beneficiary’s name, or you can withdraw the funds with a 10% penalty and you will pay federal tax on the investment gains. You can change the beneficiary on the account to another family member or friend to use the excess funds. The downside of over-saving in a 529 is the taxes and penalties involved when you don’t have an approved expense to tie them to. So, this isn’t the best place for excess savings.

Saving in an account for a child – Maybe and sometimes no.

Many parents and grandparents want to save for a child by opening a Uniform Gifts to Minors Account (UGMA) or a Uniform Trust for Minors Account (UTMA). There are some downsides to these accounts. They are designed to hold assets until the minor child attains the legal age to own securities in the state where they reside (21 in Massachusetts). At that age, the account gets turned over to the child. Some 21-year-olds aren’t mature enough to handle the responsibility of managing large amounts of money yet on their own. UGMA and UTMA accounts are also counted as assets of the child on the college financial aid form. They reduce the child’s financial aid eligibility by 20-25% of the value of the account, as opposed to parental assets which are assessed at 5.64% of the account value. This type of account is great for savings that your child is earning for themselves or for gift money they are given for birthdays and holidays that they want to invest.  It may be better for you to save in your own name and determine how much you want to give to your child as their needs arise. Alternatively, If you have the resources to fund all of your needs and you want to move money to your children, you can consider having a lawyer draft an irrevocable trust for your child, in which you decide when they get access to the money, and under what circumstances. Once you contribute the money to the trust, you no longer have control over it but the trust does offer asset protection for the trust assets against lawsuits, divorce, and creditors in most cases.

Paying Down Your Mortgage – Not usually recommended

Paying off credit card debt and student loans is always advisable because the interest rates are often high. Mortgages tend to be issued at much lower interest rates. Often, we don’t suggest that people pay off their mortgages. Waiting for rates to drop and refinancing can be a better option. If you can earn as much, or more, by investing the money, we advise that clients save rather than pay down their mortgages. Having more in your savings or investment account will give you greater flexibility than reducing the amount of your mortgage. An unforeseen event or an amazing investment opportunity may require access to cash that you won’t have if you’ve been paying down your mortgage. Ensure you have plenty of savings before opting to repay your mortgage sooner.

Increase your savings or investment accounts – Yes!

If you have an emergency account funded, you are maximizing your contributions to your retirement accounts, you should contribute to your investment account. You can set up automatic transfers to an investment account to go in monthly or quarterly. If you have funds that are needed within the next 12 months, keep that money in a high-yield cash savings account, rather than invested in the market.

Gifting – Yes, and…

In cases where you have enough resources to meet all of your needs, you may want to push assets down to the next generation to prevent your taxable estate from becoming too large.  In this case, making use of the annual exclusion gift is a great way to pass assets down to children or grandchildren.  You can give an individual up to $18,000 in cash or securities each year.  When gifting larger amounts, you need to fill out a tax form, and the amount over $18,000 will count towards the amount you are entitled to give at your death.  For example, a married couple can gift up to $36,000 to an individual.  If you want to gift to grandchildren, consider front-loading a 529 account with up to 5 years of annual exclusion gifts in the first year.  You aren’t eligible to give another exclusion gift during those 5 years, but the money will begin working in the first year.  For more on this topic, look for next month’s article which will be focused on passing family wealth down to the next generations.

In terms of the hierarchy of savings, build your emergency fund first, then max out your retirement account. After that, save for yourself and if you are able to put money aside for college, do that, but not if it jeopardizes your ability to save for your own retirement. Remember, they make loans for college but not for retirement. If your financial situation improves as times go on, you can help your child by contributing more to their college fees, or you can assist with their college loans. Focus on taking care of yourself first and maintaining your flexibility.

Connect with the Twelve Points team today to determine the best place for your extra savings given your unique situation.

PLEASE SEE IMPORTANT DISCLOSURE INFORMATION at www.twelvepointswealth.com/disclosure


Recommended Posts